REITs: Should You Invest In Them?

REITs, or real estate investment trusts, are securities that sell like stocks and invest directly in real estate. REITs are required to invest most of its assets in real estate and distribute 90% of their income into the hands of investors, so they typically have sky high dividend yields. Since these companies can only keep 10% of their taxable earnings to qualify as an REIT, its important to note that some of these companies may be highly leveraged (which increases risks and can have disastrous results as the financial crisis of the past year has surely taught us) since they must either sell or borrow shares to raise capital. Always know what you're getting into before making an investment choice.

REITs are either mortgage or equity focused - most of the mutual funds are equity. Obviously, real estate is down huge in the past couple years and the Vanguard REIT Index ETF (VNQ) is down approximately 50% in just the last year. In my opinion, it's a good time to buy real estate at these depressed levels in most markets and sectors - using the same logic, REITs might be a good investment choice for you at this current level.

Another benefit of REITs is increased diversification due to the fact that their performance is not highly correlated with the rest of the market. In fact, REITs oftentimes move in the opposite direction and thus can provide protection against the downside and are key to true diversification. As the below graph indicates, since 1992 equity REITs have had around a 38% correlation with the S&P 500. If, however, you already own real estate, owning an REIT might be repetitive and subject you to more risk by having too many of your assets in one particular sector.
(click to enlarge)
Since REITs distribute the vast majority of their income in the form of dividends, which are typically taxed at your regular income tax rate instead of the lower qualified dividend rate of 15%, it makes the most sense to hold REITs in tax-deferred retirement accounts such as an IRA or 401(k). Having a small portion - say 10% - of your retirement equity assets in a reliable REIT might make sense. Pay attention to what types of real estate a particular company invests in - commercial, residential, etc.

The performance of REITs historically even before dividends haven't been shabby either:

(click to enlarge)
I picked up a small position in Annaly Capital Management (NLY) with a 16% dividend yield about three months ago (up 11% since then). Even if the REIT stock price is flat, these dividend yields lead to great margin of safety and reliable income in your retirement accounts (assuming a strong balance sheet and good prospects). They really pay you to wait. And since people in the last couple years have avoided real estate like the plague, now might be a good time to get in. If you don't want to research particular trusts and continue to monitor them, investing in VNQ (with a 9% dividend yield) is probably the best bet.

The New York Times' Vivian Marino suggests looking at six key factors when analyzing a REIT: management, asset quality, growth prospects, balance sheet, value, and yield.
  • Management - Since REITs are not merely investing in commercial real estate, you are actually depending on a management team to completely decide which assets are wise to buy and sell. Leaders in the field also get the first crack at numerous transactions in the sector.
  • Asset Quality - If you had chosen an REIT that only invested in Florida and California, you wouldn't be so happy right now. Look for companies that invest in areas that always have demand (such as strong urban areas) and hold diverse holdings.
  • Growth Prospects - Just as growth is a key component of any stock, growth for an REIT is especially important.
  • Balance Sheet - Check out the F.F.O.
  • Value - As with any other investment, it pays to find companies that are selling below what they should be at based on their fundamentals.
  • Yield - Dividends are the most appealing aspects of REITs, but just finding the company with the highest yield isn't necessarily the best bet. However, there are some accidental high yielders out there that can really provide a good steady income stream over time.
Check out for more information on investing in REITs.

Roth IRA vs. Traditional IRA vs. 401k vs. Roth 401k

With so many investment vehicles for your retirement funds, which one makes the best sense for you?

Obviously, it varies based on your objectives, but there are definitely myriad variables to consider when choosing where to stash that retirement money. I'll highlight some of the generic differences that are typical in these types of articles (just google Roth vs. traditional IRA to find a plethora of articles and advice), but the main purpose of this post is to delineate some of the key differences that are inexplicably omitted or barely mentioned in those other articles.

For a great highlight of the differences, see Wikipedia's 401(k) IRA Matrix. Obviously, as always with Wikipedia, confirm with another source (IRS publications are linked on the page) that the information is correct. That matrix, though, certainly gives a good basis for comparison in a easy-to-read format that I've seen nowhere else. I'll also refer to a general 401k and traditional IRA both as "traditional" to simplify wording and avoid confusion. And there are certainly differences between the Traditional IRA and 401k (as well as the Roth 401k and Roth IRA) that should be investigated (consult the Wikipedia article) that I may gloss over for the sake of simplicity once again.

The Basics

First, let's go over the basics just so we're all on the same page. Essentially, the main difference is that the Roth versions are post-tax money; thus, taxes don't have to be paid later in life during normal distributions. On the other hand, a Traditional IRA (or 401k) is tax deferred and then taxes at the normal income bracket level during distributions (although technically a Traditional IRA is post tax money at first until your filing for that tax year comes up on April 15, at which point it becomes deferred). At the very simplest level, it's the difference between paying tax now versus paying it later. The traditional versions reduce your tax bill for the current year (assuming it's a 401k or deductible IRA; there are non-deductible Traditional IRAs as well that are suitable for high income investors to open and then immediately convert to a Roth), while the Roth versions will reduce your taxes later in life.

With that in mind, if you think your tax bracket will be higher when you take distributions (take your money out of the account during retirement), then it makes sense to put money in the Roth versions and use post-tax money (it's important to note that the Roth won't ever increase your tax bill, it just won't reduce it; while the traditional versions decrease tax liability now and increase it later). On the other hand, if you anticipate being a lower bracket during the distribution phase, then it makes sense to reduce your tax bill now and contribute to a traditional version and pay the taxes later.

Complicating these predictions is not only the unknown of your future income, but the unknown of government taxation protocols.  Because of the unknown, some financial planners espouse "tax diversification" - contributing to both types so that if you guess wrong, you aren't hit as hard. If your tax rate stays the same from contribution to distribution, then the Roth and Traditional versions will essentially have no difference on the bottom line (although there are certainly a variety of other differences).

In general, I like to recommend the Roth IRA (especially if the Traditional IRA is non-deductible due to exceeding AGI limits; again, open the Traditional IRA and immediately convert to a Roth if your AGI makes you ineligible to open a Roth IRA directly) to the majority of people for a variety of reasons which will be elaborated below. However, I also think that there's some logic behind tax diversification, and think a 50/50 split would be appropriate for most individuals.

On somewhat of a side note, the power of tax deferred compounding of assets (i.e. using retirement accounts) is remarkable. You should contribute as much as you can as early as you can to truly see the power of compounding and the savings you will have over the course of 40 years avoiding paying taxes to the IRS is astounding. See the graphic above to illustrate this key point.

Contributing to Retirement Plans

Getting back to the topic at hand, here's the general order I typically recommend investors to stash their retirement money:
  1. First, contribute to your employer's 401k plan up to the employer match. If they match 50% of the first 4% of your salary, for example, always contribute the full 4%. This is a free money; you can't get much better than that. Pay attention to vesting schedules to see when the money in the account actually "becomes yours." Note that all matching contributions are treated from a tax-perspective in the "traditional way." That is, even if you're only contributing to a Roth 401(k) (post-tax money), your employers' contributions will be tax deferred. That instantly gives you some of the tax-diversification I was earlier talking about.
  2. After getting to the maximum employer match, contribute as much to an IRA as you can. The maximum IRA contribution for 2009 is $5,000 a year if you are below age 50, and $6,000 if you are 50 or above (assuming you are eligible based on your MAGI). The reason I like putting this second segment of money into an IRA instead of a 401(k) is because of the exponentially more investment options you have with your own plan and the flexibility involved.  A Roth IRA is typically preferred since a Traditional IRA is only tax deductible if you are below a certain income limit and your employer does not offer an applicable retirement plan.
  3. If you make too much money to contribute to an IRA or you still have more money you want to shield from the IRS after reaching the maximum allowable in your IRA, the next place to put your money is in the 401(k) up to the allotted $16,500 (below 50) or $22,000 (50 and up). The limits for the 401(k) are much higher than the IRA, and these funds can later be rolled over into an IRA account (which I recommend to simplify things and also for the increased flexibility) upon termination of employment.
We now understand the basic differences between Roth and Traditional retirement accounts as well as the order in which to contribute (for what to invest in, see my Investing Advice for the Masses and Lazy Portfolios posts). To reiterate an important point, a 401(k) or IRA is not an investment in itself; it is an effective vehicle in which to hold investments. Thus, even if you play the game perfectly about your contributions and where to hold them, if you make poor investment choices, you won't fare well.

Along the same lines, financial advisers and commentators frequently talk about the importance of the contribution and accumulation phases of the retirement accounts, while completely neglecting the distribution phase. During a basketball game, do you only try in the first three quarters? No! The fourth quarter is where you put the pedal to the metal and see what you're truly made of. It determines the outcome of the basketball game. It's the same with retirement accounts. If you make lousy decisions during the distribution phase, your great decisions during the other phases won't mean as much. Of course, it's much easier to win the game in the fourth quarter if the first three quarters went very well.

The Roth IRA Advantages

Finally, let's discuss the positives of the Roth IRA that typical articles don't even mention that I find truly significant:
  • Contribution limits are effectively higher for the Roth. What? Didn't I just say above that for an IRA that limit is $5,000 (if under 50) for both types? Yes, that is true, but since the Roth contributions are post-tax money, the limit is $5,000 post-tax. In essence, if you're in the 25% tax bracket, it's like you're contributing $6,666 to a traditional account. (Not that the $1,666 is free money, just that you have an additional $1,666 to start your investments from that avoids the IRS for all those years). Roth accounts let you get more money into them and help your bottom line.

  • Keep all your money in the Roth IRA for yourself and for your children. Since you used post-tax money in the Roth account, the account balance that you see is what you'll get. Obviously, the Traditional IRA allowed you to avoid taxes earlier in life, but I like the added simplicity of seeing an account balance and knowing you get to keep it all. On top of this, in a Traditional IRA you are forced to begin distributions at 70 1/2, while a Roth IRA has no such forced distributions. Thus, if you are planning to leave an inheritance to your children, you not only get to avoid the IRS for even more years, but you'll actually know how much you're passing on! There are far too many times when children are thrilled with the balance of their rightful inheritances from a parent's retirement account only to be hit with HUGE tax liabilities. They don't know what hit them. Help your children avoid that and contribute to a Roth IRA. Even if you didn't contribute to the Roth version at the onset, you can easily rollover your traditional IRA to a Roth IRA and just pay taxes in the year of conversion. Likewise, you can rollover your 401(k) to a Traditional IRA, and then roll that over to a Roth IRA. Your children (and your aging pulse) will thank you for actually giving them the amount they anticipated.

  • But the most significant advantage of the Roth IRA over Traditional IRA that is hardly ever mentioned in articles is that all contributions to a Roth IRA may be withdrawn at any time for any reason penalty and tax-free. That is truly astounding! With the unpredictable game that is life being played, it's hard for certain people to contribute a lot of money towards retirement and not be allowed to see that money again for forty-some years when you turn 59 1/2. What if something happens that you need that money? (There are exceptions for education, medical expenses, and a home purchase in which you can withdraw money from non-Roth accounts without penalty). In normal circumstances, withdrawing money from a traditional retirement account early is tantamount to shooting yourself in the foot. Not only do you have to pay taxes, but you have to pay a 10% penalty. In those cases, it would have been better not having money in your retirement account at all. To avoid this doubt and uncertainty, contribute to a Roth without looking back! This is with a caveat: if you lack discipline and need to have your money inaccessible so that you won't touch it, maybe this positive is actually a negative for you. If you change your mind, you can always take out your contributions without any sort of penalty. It's important to note that you can only take out up to the amount contributed to the IRA. So, any income generated from your investments (which hopefully there is some) must remain in the retirement account until the appropriate time unless you want to pay the 10% penalty. Also note that a Roth 401(k) is slightly different than a Roth IRA and has more restrictions (hence why I earlier said I prefer the IRA due to increased flexibility). I have no idea why more articles don't emphasize this point. Life is unpredictable. Having the ability to "undo" something without being penalized is a huge benefit, although you certainly should strive to keep all your money in the retirement accounts due to the immense power of tax-deferred growth.  Note that a withdrawal from a Roth 401k is not the same.   You have to have the account opened for five years and the proportion of withdrawal must equal to the proportion of profits to contributions, which is then subject to 10% penalty if you're under 59 1/2 plus tax.  So, contributions from a Roth 401k cannot be easily at all as you're forced to wait 5 years and pay tax on some of it. 

    There you have it. A simple breakdown of some of the differences between these accounts, where I think it makes sense to put your money, and the advantages to the Roth IRA that are often overlooked. Good luck!

    Useful Investing Tools

    Following is a brief list of websites and tools that I have found useful in investing:

    • Morningstar - Articles, stock, fund, and ETF quotes, returns, performance, and holdings, investing tools, and discussion boards among other features. Overall, a solid site particularly for analyzing the holdings and hypothetical growth of mutual funds/ETFs. Certain articles and tools require a subscription.
    • Morningstar's X-Ray Tool - Analyzes the holdings of your portfolio by asset allocation, stock style, sector, stock type, world regions, and fees and expenses. This is a vital tool for any investor and should be tested against your portfolio periodically to confirm you're matching your desired asset allocation and risk level.
    • Google Finance - Google Finance is newer to the game than many other sites, but I find the graphical interface for stock and fund performance the most user-friendly of any site. Its news feed feature is also beneficial to get the latest commentaries on various companies. However, it lacks many important tools such as technical indicators and other important fundamental figures. I use it to track my own portfolio since I'm always logged into gmail, anyways. But I wouldn't solely depend on Google Finance to monitor my investments. (Update: Google Finance has had a facelift and new features have been added such as technical indicators).
    • Yahoo! Finance - Where Google lacks, Yahoo! excels. This site provides much more information with more active message boards, as well as key information, interactive charts with technical indicators, detailed financials, analysts opinions, company profiles, historical prices adjusted for dividends, and more! If there's one site to go to, it's Yahoo! Finance. I just wish the graphical interface was as well laid out and user-friendly as Google's.
    • Wikinvest - An investing wiki that has personal finance, generic investing, and commodity, industry, and company specific articles as well as charts, financials, and industry-specific data metrics (that are compared relative to their competitors) for individual stocks.
    • StockCharts - A site with some nice charting abilities. Especially useful are their comparative performance charts.
    • Wall Street Journal - All investors should read it. No more to say.
    • CNNMoney - Personally, I'm a fan of the layout and the simple, concise day-end market recaps on the site. I particularly enjoy Paul La Monica's The Buzz.
    • Sector Performance - Monitoring the cyclical nature of various sectors is important to get a grasp of the macroeconomic factors at play. Fidelity was the pioneer in offering sector-specific funds and still is the leader. If you're using a sector-rotation strategy or just want to see general performance figures of sectors offered, check out the linked site. Alternatively, look at the performance of Select Sector SPDR ETFs here.
    • ETF Screener - For the ETF investor, this is a really helpful screener to find the ETF that meets your objectives.
    • FinViz - This site really has some unique features for free such as a heatmap, a detailed screener, and informative charts, data, and news about particular stocks.  I could see this site being a must-see for traders.  They also have a paid for Elite version, but the free website has ample functionality, in my opinion.
    • Cake Financial - Automatically tracks your trades and performance of your individual and retirement accounts. Analyzes your portfolio, compares your return to that of the S&P 500 as well as other users, categorizes investments, gives suggestions that match your investing profile, and more. The most useful aspect of it that I have found is that it automatically links to your brokerage accounts and keeps track of all your positions in one place. If you have multiple accounts with various companies, it's useful to have it automatically organized and cataloged. (Update: Cake Financial has been acquired, and destroyed, by E*Trade as of 1/14/2010 without warning. Apparently, E*Trade is going to incorporate certain features into their own site, but didn't find the user-base and site traffic promising itself on its own to keep it afloat. An alternative social investment site that I like is out of Israel.)
    • Bogleheads Wiki / Forum - A variety of helpful generic articles by those that adhere to the John Bogle (founder of Vanguard) investing philosophy of low-cost index fund investing for the long-term are in the wiki. The forum provides a great place for questions about asset allocation and risk for particular individual circumstances, as well as generic investing questions. There are a plethora of individuals who would be happy to answer your portfolio questions and assuage your concerns.
    • The Motley Fool - It used to be a solid site with some nice articles. It has gone downhill since, with the articles being brief and short on analysis, and everything becoming a sales pitch for one of their newsletters or "secret stock-picking" services. I don't visit it as much, but it occasionally has a nice article or two.
    • - Daily commentary on market activity, trends, and more.
    • Recent T-Bill Auction Results - Keeping on eye on the T-Bill rates is useful.
    • - Contains some nice features such as analysis of momentum and trends, how much to risk on a particular position, and more.
    • MSN Money - I really only use this site for one feature; it lists the top 25 holdings of a particular fund instead of the top 10 holdings most sites do. You can easily get quotes for all 25 stocks as opposed to just 10 on Yahoo! Finance. Always check the fund/ETF prospectus to confirm the latest holding information.
    That's all I've got for now! I might add more later.

    Investing Advice for the Masses

    The past two days I have outlined and analyzed strategies for individual investing. In the posts, however, I have alluded to the fact that I don't think either of those strategies are relevant or smart for the large majority of individuals. So what strategy does make the most sense for the largest segment of the population? We're going to explore it in this post.

    Investing Philosophy

    Matching the market is incredibly easy, while beating the market is incredibly difficult. It's that logic that guides my principles to individual investing - a simple, well-balanced, appropriately allocated mixture of funds that allow for long-term growth when dollar-cost averaging into the funds over a significant period of time. Another saying that implies the same thing is "Keep It Simple Stupid" or the KISS principle. For most people, keeping it simple will optimize returns and will allow you to better understand your investments, which is vital for any individual. These practices are espoused by financial planners and have proven time-and-time again to be effective at beating most Wall Street types as well as portfolio and fund managers. That is because of the fees associated with increased complexities in investment choices.

    One doesn't need to financial adviser to make sound investment choices - in fact, his or her fees just eat into your gains. If it makes you feel more comfortable with your assets to meet with an adviser, there is certainly nothing wrong with it. Just make sure they are fee/hourly only and not on commission (those on commission are more like salespeople who try to sell you investments such as variable annuities that most likely you do not want).

    Where to Invest

    Ok, so let's get down to it. How can you be diversified and match or beat most Wall Street investors after fees are taken into account? Low-cost index funds.

    Besides the investment objective and holdings, the net expense ratio is the most important aspect of a mutual fund. Vanguard is especially known for its offerings of great, low-cost options. Charles
    Schwab (which recently reduced its ratios to rival Vanguard and has lower minimums, as low as $100, if you don't have much to invest) and Fidelity are other good choices. You shouldn't pay more than 0.25% for index funds.

    Passively managed index funds beat 60-70% of actively managed funds on a yearly basis after expenses are taken into account. Sure, you could be lucky and choose one of the 30-40% of active funds that beat the market in a particular year, but that fund typically then
    underperforms the market the next year. There's no way to know - historically, it has been irrefutably demonstrated that staying in index funds over the long-term increases the likelihood of maximum returns. In fact, over a ten year period, a full 95% of actively managed funds trail market averages after taking expenses and taxes into account. Thus, sticking with high quality, low-cost passively managed index funds over the long-term is clearly the way to go to maximize returns.  Pick up and read Will McClatchy's Strategies for Investment Success: Index Funds if you want this beaten into your head and a plethora of data supporting this claim.

    Another problem most people have in their portfolios (both retirement and normal) is that they have redundant and repetitive funds or "closet-index funds." Both are bad things to have. I know many individuals have twenty or so funds, and many of them are nearly identical with the same objective and very similar holdings. (Side note: avoid front-end and deferred loads at all costs). Trim the fat! Invest in only the lowest cost fund. "Closet-index funds" are funds that advertise as actively managed funds (and charge near 1.0%), but when you dissect its holdings, it is essentially an index fund. Those should be avoided like the plague.

    Now that we have a basis for understanding the philosophy and logic behind
    simple, dollar-cost averaged low-cost index fund investing for the long-term, we can give a more detailed layout of what your holdings might look like. The allocations of stock to bonds obviously shift as you age, so that should be taken into consideration.

    You do not need 30 mutual funds to get invested in every sector in the market and every asset class without redundancy. In fact, I'd argue that it's actually more difficult to be diversified with that many funds.   Money Magazine's Michael Sivy, Carla Fried, Carolyn Bigda and George Mannes, wrote a nice article, which I will summarize. Here are the only seven investments you really need according to them:

    1. US Index Fund - Choosing a low-cost blue-chip US Index fund should be the staple of any investor. International holdings (especially Latin America, Eastern Europe and other emerging markets) have been the rage over the past 10 years (although they were obliterated last year), but historically US firms are the bread and butter and account for a significant portion of the world's economic equity value. US stocks have have grown eightfold after taking inflation into account since 1908, while gold has only doubled. Recommended funds (symbol; net expense ratio): Vanguard Total Stock Market Index (VTSMX; 0.18%), Vanguard 500 Index (VFINX; 0.18%), Schwab S&P 500 (SWPIX; 0.09%), and Fidelity Spartan 500 Index (FSMKX; 0.10%)
    2. Foreign Stock Index Fund - Most of the growth and economic activity comes from outside the US. In order to be truly invested in this global market, you need an international index fund. On top of that, having foreign investments increases diversification. US and foreign markets aren't always in lockstep direction, so having a piece of both developed and emerging markets outside the US is key to true diversification.
      Recommended funds
      (symbol; net expense ratio): Vanguard Total International Stock Market Index (VGTSX; 0.34%) and Schwab International Index Inv (SWINX; 0.19%).
    3. Small-Cap Fund - In order to capture the growth companies and "the next Microsoft" you need to have some money allocated to a small company fund. These have historically outperformed large-cap stocks, but you must realize that there is increased risk involved. The greater the risk, the greater the reward. It also gives you extra diversification. Check out NAESX.
    4. Value Fund - Similar to small-caps, value funds have outperformed large-blends over long time periods. These stocks also typically pay higher dividends and are purchased for "discounted" prices. Check out VIVAX.
    5. All-Encompassing Bond Fund - Stocks will be the majority of your portfolio for most of your life, but bonds are necessary to reduce risk and increase diversification at all times. The income is more reliable and they have still returned around 7% since 1998 (beating stocks). Rather than choosing a short- or long-term approach to bonds, it's easiest to just invest in a total bond fund such as VBMFX. Hold bonds in retirement accounts, if at all possible, due to the tax ramifications. Your stock portion should be in taxable accounts and the spillover (hopefully, it's significant) should be in retirement accounts.
    6. Inflation-Protected Bond Fund - Inflation destroys purchasing power. Averaging about 3% annually, inflation can take a big chunk out of your investment gains if you don't play it properly. To counteract the effects of inflation, it's wise to put some money in TIPS (Treasury Inflation-Protected Securities). Check out VIPSX.
    7. Money market fund - It's essentially a cash account, but there are times when you need to take advantage of buying opportunities or have extra emergency cash available. Certainly, it makes sense for this to be a small part of your portfolio.
    So, that's it! If you have more than that, you might have redundant holdings and should consolidate the funds.  I'd note that having a Small (3) and Value (4) fund isn't entirely necessary in my mind.  I'd encourage the use of a single Small Value fund, like VISVX, as reported in my Lazy Portfolios post, but you could just as easily have neither.  If you're early in your career, you also don't necessarily need a TIPS fund as your salary increase should correspond with inflation somewhat.  And some prefer using savings accounts to money market funds.  Thus, there are really only three funds you absolutely need - a US equities, international stock, and a bond fund.

    If your 401(k) provider doesn't necessarily provide the exact replica (mine, for example, doesn't give a TIPS fund as an option), but you should do your best to find suitable replacements or purchase it in an IRA. Dollar-cost average into these funds over the long-term and you will be on your way to outpacing the majority of the public because of your reduced fees and simple approach. I'd also encourage investors to look into holding an REIT fund in retirement accounts, such as Vanguard REIT Index (VGSIX; 0.26%). For why REITs make sense in retirement accounts, see this post.  I wouldn't find it outrageous, however, to not hold an REIT fund as you're already holding REITs in market weight with a total market fund (and Small Value funds also hold a larger percentage of REITs traditionally).  

    Simplifying Your Portfolio

    Allan Roth agrees that only the three funds I mentioned above are
    really necessary to be truly diversified:

    • Vanguard Total Stock Market Index (VTSMX)
    • Vanguard Total International Stock Index (VGTSX)
    • Vanguard Total Bond Market Index (VBMFX)
    The return of the three-fund approach vs. the seven-fund approach is negligible and the increased simplicity as well as reduction in re-balancing (easier to re-balance three funds as opposed to seven; you should re-balance once a quarter), might make it worth it in some circumstances.

    In an article linked on his website, he shows how his second grade son took on Wall Street with this simple approach.

    I'll take it even one step further and suggest how you can be truly diversified using
    one fund from the options in Vanguard's LifeStrategy or Target Retirement Funds. Yes, that's right - just one fund that won't require any re-balancing. I'm not personally a fan of how target retirement funds adjust their allocation as you age (just ask those who were planning to retire in five years and invested in the Target Retirement 2015, which was down nearly 30% last year), but I do find them as great tools to diversify with less capital. For a simple all-in-one portfolio, you could certainly do much worse than these funds, especially if you don't have much to invest. For example, if you wanted the Total Bond Market to be only 10% of your total portfolio, you'd need $30,000 in assets to invest to get the appropriate allocation by using single-purpose funds (since Vanguard typically imposes a minimum of $3,000 per fund). By the way, you should consider all your accounts (taxable, 401k, IRA, etc.) as a single entity when determining and evaluating your overall asset allocation. To get around the minimum and/or simplify your portfolio's holdings and re-balancing, you could simply invest in Target Retirement 2050 (VFIFX), which in turn invests in the total stock market, total bond market (at 10% of its total holdings), and total international equities. All in one fund!

    LifeStrategy funds have a similar principle in that they invest in a variety of Vanguard index funds with a single fund. It's really a great option if you can't handle keeping track of more than that. An aggressive allocation goes something like 70% Total Stock, 20% Total International, and 10% Total Bond. A moderate allocation is 40%, 20%, and 40%, respectively. While a very low-risk, income generating allocation is around 20%, 10%, and 70%, respectively. However, LifeStrategy funds are not ideal choices for taxable accounts due to the tax inefficiencies as I outlined in my first Q&A; they hold the Vanguard Asset Allocation Fund, which adjusts its allocation and thus realizes capital gains. Therefore, the Target Retirement funds are preferable for taxable accounts (ignore the year and simply examine the stock/bond percentages that match your desired allocation).

    As I previously alluded to, if you want to practice tax-efficient investing (as you probably should), these all-in-one fund solutions might not be the ideal choice (although the simplicity of such funds might be worth it). Bond funds and REITs are more tax inefficient than stock funds and are thus best held in tax-advantaged accounts, while the stock portion should be in your taxable accounts. For principles of tax efficient fund placement, see this article.

    For a discussion of eight pre-screened portfolios using the low-cost index fund approach, see my article on Lazy Portfolios. The portfolios vary from 3 funds to 11 funds and offer investors a great resource for do-it-yourself portfolios. You can slice and dice funds as you see you fit based on your own personal circumstances or keep a more simplified approach.

    Analysis of Portfolios

    Morningstar's free X-Ray tool is a great way to analyze your portfolio holdings. Using an allocation of 70%/20%/10% with the three funds vs. 100% in the Vanguard Target Retirement 2050, you can see the similarities and negligible difference from a composition standpoint (note that tax ramifications should still be considered, however).

    (click to enlarge)

    Source: Morningstar, Inc.

    They are nearly identical! If I did the same assessment with the seven funds, I'm certain is would be very similar as well. Note also that the expense ratios are both below 0.2%, while
    Morningstar indicates that a similar hypothetically weighted portfolio typically costs around 1.2%. One percent may not sound like a significant difference, but with the power of compounding over the course of several years, that really adds up! So, not only have we simplified the investing approach to fewer than seven funds, we've reduced expenses, redundancy, and increased your potential for better returns!

    Here is the analysis with all seven funds with the following aggressive, early in career allocation: 60% US Blue-Chip, 20% Total International, 5% Value Index, 5% Small-Cap Index, 7.5% Total Bond, and 2.5% Inflation-Protected Securities.

    (click to enlarge)
    Source: Morningstar, Inc.

    Notice the similarity. It is
    very slightly more skewed towards value (37% vs. 34% for other two portfolios) and large-cap (again, 3% difference). But, in the end, there is little difference and the performance of all three strategies will be quite similar. If you have enough funds wherein it makes sense to more broadly diversify across several non-redundant funds, then perhaps it is logical to use them all. Otherwise, don't sweat it and use the three- or one-fund approach without looking back.


    In the end, remember that it's
    incredibly simple to match market returns and be truly diversified as long as you pick appropriate funds that you understand. Although this may be a "boring" approach, it has proven to be effective and out-performs the majority of investors who attempt to pick hot funds, stocks, time the market, and use other trading or investing techniques. If you have the time, knowledge, and interest in picking individual stocks or investing in other asset classes, then there's certainly nothing wrong with doing that with a small portion of your total portfolio - say 5-10%. But even in those cases, the vast majority of the portfolio should encompass the aforementioned boring approach.

    For the
    majority of investors, this simple approach is by far the best option. It's not even close.

    Eight Criteria to Use When Picking a Stock

    Yesterday, we examined whether a simple market timing strategy can actually work over the long-term. Market timers, such as Sy Harding, frequently shun those who attempt to pick individual stocks to beat the market. Harding used the performance of Warren Buffett ("the greatest investor in the world") last year to declare that it is nearly impossible to win at the stock-picking game. Certainly, Buffett's performance was not the prettiest thing in the world as he had some missed calls such as paying a premium for COP, but who doesn't have a missed called every once in a while?

    [begin tangent] While Buffett's performance of his BRK.A shares were down about 32% (compared to -39% for the S&P 500) last year, to suggest that Buffet's lifelong record of stock picking has been anything less than remarkable is ridiculous. In the long-term game that is investing, if you had invested with Buffett at the onset in 1965, your $10,000 would be worth $51 million today! Investing in the S&P would have left you with a nice chunk of change to the tune of $500,000, but that's just ONE percent of $51 million. In addition, due to these stellar results, investors were willing to pay a premium for BRK.A. As with any company, its stock price isn't solely determined by the performance of investments and its bottom-line profit. As we all know, there is a lot more that goes into determining the price. In fact, in Berkshire's annual report (all investors should read these every year as they provide keen insight from the master himself in a clear, concise fashion), Buffett cited something around a 10% loss in his investments - far from the 32% decrease in the stock price. On CNBC's Fast Money last night, Dennis Gartman (who previously said that Buffett was an idiot), stated that Buffett made some "terrible mistakes" last year, which lead to "inexcusable losses." While he took back his idiot remark, he didn't shy away from his criticism of Buffett. Well, in my opinion, Gartman is an idiot. He historically has been critical of all passive buy-and-hold investors. Buffett isn't a trader like Gartman likes; he's an investor. There is a distinct difference and a future blog post will elaborate on this more fully.[/end tangent]

    As stated yesterday, those that purchase individual equities typically insist that market timing is a futile affair and leads to poorer returns. Personally, while I think for the vast majority of individuals it makes the most sense to use all their funds to dollar cost average into low-cost index funds over time, I do think that those with the time, inclination, and interest can augment their core holdings (i.e. index funds) with individual stock picks in an attempt to modestly outperform the market.

    Here are eight criteria I use when choosing a stock:

    1. Bullish sector - Sectors go into and out of favor based on natural transitions as well as the current economic climate. Oftentimes, these changes are cyclical and predictable or fairly obvious based on economic indicators. Other times, however, it can be difficult to ascertain which sectors are poised to pop. Additionally, yesterday's hot sectors can quickly turn cold, and certain sectors are more volatile and risky (e.g. technology) than others (e.g. consumer staples). All of these factors should be taken into account. You can consult Standard & Poor's or Ned Davis Research for detailed analysis of their weighting recommendations, if so desired. A stock price is not only affected by a company's own fundamentals and earnings reports, but that of its peers in the same industry. Right now, for example, both agencies both recommend overweighting the IT sector. This would be a good place to start looking for a stock. 
    2.  Low P/E relative to its competitors - Looking for value is a staple tactic of any long-term approached investor. Traditionally, value picks have fared better over the long-term than growth stocks. Growth can provide a boost and should certainly be considered an important part of any well-balanced and diversified portfolio, but value is something that cannot be beat. P/E, or the Price to Earnings ratio, is the "real" cost of a stock and should be used to determine if a stock is cheap or expensive - the absolute value is fairly irrelevant. Companies with expected high growth usually charge a premium and exhibit a higher earnings multiple. Let's compare two similar companies: Edwards Lifesciences (EW) and Becton, Dickinson and Co. (BDX). Both are in the Health Care Equipment Industry (not something I necessarily recommend at this juncture, but I'm using it for illustrative purposes only). EW's actual price is 65.15, while BDX is at 68.6. So, BDX is slight more expensive, right? Wrong. EW's P/E is at 22.54, while BDX is at 14.84. So BDX is actually about 34% cheaper; quite a discount. Thus, all else being equal, I'd always buy BDX. 
    3. High growth and low PEG ratio - While a low PE typically indicates low growth, there are some diamonds in the rough out there and stock prices don't always perfectly reflect the numbers. It's our job as individual investors to seek out these deals, and then pull the trigger. I like to look at the 5-year projected earnings growth. Combining the last two criteria, one can just look at the PEG ratio of a stock. The lower the PEG, the more the stock is undervalued. Using EW and BDX as above, BDX has a PEG of 1.2, while EW is at 1.5 - yet another reason to choose BDX over EW. This is just a logical extension of the fact that BDX has a much lower P/E. EW's projected growth would have to much larger to make up for it. 
    4. Reasonable dividend yield - While traders could care less about dividends, I believe the vast majority of people should go into the mindset of being an investor. It has been shown time and time again, that high quality dividend-paying stocks are largely responsible for the average 10.3% rise in equities since the 1920s. It provides protection against the downside, and it is nice getting a check every once in a while, especially considering that the yields on many stocks are currently higher than anything you'd get in a savings account or CD. It's important to note that some sectors traditionally do not have high yields (e.g. tech, banks), while others have more precedence (e.g. consumer staples, REITs). Also, it may be a concerted effort on the part of management to not pay dividends so they are able to dedicate those assets for future growth and to help investors avoid paying taxes on that cash. Warren Buffett's Berkshire Hathaway (BRK.B), for example, uses this rationale and does not pay dividends. I would not automatically avoid such a company, but I still do think that it makes sense to have a stream of dividend income and seek out such companies. I reinvest my dividends in tax-deferred accounts, while I prefer to have the dividends automatically put in my savings account (or money market) for taxable accounts due to accounting. Check out for information on how reliable a particular company has been at paying and raising its dividends. Current stocks with high yields right now (that I believe are "safe;" too high of a yield is a red flag) that look attractive in my mind include BMY, VZ, and JNJ. 
    5. Normal debt-to-equity - I don't like investing in companies with exorbitantly high debt-to-equity ratios. While financing its growth with debt can be a positive, having too much debt is a red flag in my mind and I like to stay away. On the other hand, a company that plays too conservatively may be missing out on growth opportunities. "Normal" depends on the particular industry - so you'll have to research it. 
    6. Positive Industry Specific Metrics - Nearly every industry has key metrics that illustrate how a company is being managed and performing. Looking at these particulars can help investors gleam insight into a stock price even moreso than the generic valuation measures. For example, in the restaurant business, sales per restaurant is a key statistic. You need to do some research to discover what metric is particularly foreboding for future success and how companies are judged relative to their peers. A good site to check out for such information as well as how a particular stock compares to its competitors is Search for a stock, click data central, and there you will see an Industry Metrics section. 
    7. Low Price to Book, Low Price to Sales, High Return on Assets, and High Return on Equity - These are all valuation metrics helpful in determining if a company is undervalued. The Price to Book (P/B) is simply the share price divided by the book value per share. This varies widely based on industry, so again, it's best to compare it to its peers. For example, a company that is dependent on services will have a higher P/B than an industrial that requires far more assets. P/B certainly shouldn't be looked at in a vacuum as a low number could indicate a variety of problems such as poor earnings projections or negative investor sentiment. Price to Sales is calculated by dividing the share price by the revenue per share. A stock with a low price to sales when compared to its peers is seen as undervalued, but also can signal other issues, so it's careful to seek out if any such negatives exist. Return on Assets (ROA) is the net income divided by assets (or sometimes net income plus interest divided by average assets). It measures how efficiently a company utilizes its assets to generate earnings. This should be compared to its previous ROA as well as its competitors current ROA. Return on Equity (ROE) is net income divided by shareholder equity and measures how effectively a firm profits from funds raised by shareholders. All else being equal, a higher ROE is better. 
    8. High Operating Margin / Net Profit Margin - Operating Margin is simply operating profit divided by net sales. It gives an idea of how much money a company makes for each sales dollar it earns. For example, a company that has an operating margin of 20% earns 20 cents for every dollar of sales. A higher margin allows a company to more easily pay fixed costs such as debt interest and signals healthy cash flow. Similarly, net profit margin is net income divided by net sales. It's how much money a company gets to keep for each dollar of sales and is used in tandem with operating margin. These metrics can signal the forward progress of a company. If you simply looked at net income and saw that it increased year-over-year, that certainly would be a positive. But if the company also reported decreasing margins, that is a negative. Conversely, a company that had stagnant income but increased margins would be seen as a buy assuming growth going forward seems likely.
                  While I certainly consider other factors when picking a stock, these eight places are a good place to start. I also recommend using a limit order when purchasing shares (never buy at the market price) and if you want to manage risk, sometimes it makes sense to place a stop loss order at a certain percentage below based on normal fluctuation. Consulting the beta of a stock or look at to get a reasonable percentage to risk and where to place to stop loss order.

                  Also, it's important to remain diversified and keep with your target asset allocation. So while I tend to choose stocks in bullish sectors, I never stray too far from the sector allocation of the S&P 500 since my core holdings include index funds. Each stock you own requires significant time and research, so if you don't have the time or interest, there is certainly nothing wrong with investing in an index fund. In fact, I recommend that for the vast majority of individuals and believe index funds should be the foundation of all portfolios. By following these criteria, one can reasonably hope to modestly outperform the market (although there are no guarantees) while making it interesting (yes, I find stock picking entertaining and fun as well as a potential to make money). So, why don't expertly managed active mutual funds routinely outperform index funds you ask? Fees. 60%-70% of actively managed funds lag the market average because of fees. This analysis is for another post. But managing your portfolio yourself, you
                  can avoid these fees and make sound investment choices.

                  Market Timing using Harding’s STS

                  Can an investor effectively time the market? Time and time again, financial planners and articles on financial websites, magazines, and newspapers, emphatically declare "No!", sometimes using a concrete statistical analysis indicating the the stock market's direction can be more accurately described using random walk, a mathematical formalization of a trajectory (i.e. it cannot be predicted).

                  They argue (occasionally citing various economic journals) that it is nearly impossible for an individual to continually enter and exit the market at the proper inflection points. In fact, market timing critics, which include the majority of the financial services industry, suggest that the emotions involved in individual investing actually leads to a significant under performance of market averages. That is, when investing on emotion, it has been shown that individuals have the propensity to buy high and sell low, completely antithetical to the mantra of "buy low, sell high." Add excess trading fees accrued by the increased number of trades to those incorrect choices in the first place, and market timers who make their judgments based on emotion routinely under perform - unless they just happen to be lucky.

                  However, even those who swear by market timing typically concede to the fact that market timing based on emotion is a fool's game. Instead, they argue, that there are systematic approaches that take emotion out of the investing game and work for the long-term. We are here to investigate one such strategy: Sy Harding's Street Smart Report Seasonal Timing Strategy (STS).

                  Seasonal Timing Strategy Basics

                  Harding claims on his website that the traditional STS was down only 3.6% in 2008 compared to -36.1% for the S&P 500. Here's the chart comparing the STS to S&P 500 for 3-, 5-, and 10-year returns, taken from the above linked website (as of 6/2009):

                  Total Return / S&P 500 / STS
                  1-Year / -36.1% / -3.6%
                  3-Year / -22.3% / +22.4%
                  5-Year / - 9.6% / +47.2%
                  10-Year / -13.2% / +132.5%

                  Taking the last ten years on an individual basis, Harding's STS on the DJIA has outperformed the DJIA in seven out of ten years (according to his analysis; falling slightly short of the market average in 2003, 2005, and 2006). It was curious to me as to why he chose to do the analysis of the STS on the DJIA instead of the S&P 500. Was he trying to make his returns look better?

                  We're here to find out if these market timing claims are valid, what type of investors might consider market timing (if any), and the difference in performance throughout bull and bear markets.

                  Also, it's important to note that just because this strategy has or has not been effective in the past (we'll soon find out), that certainly is no indication of how it may play out in the future. As they say, past performance does not guarantee future results. In fact, in regards to mutual funds, I'd argue (and studies would back me up) that hot funds typically turn cold. This is a result of various factors, but most significantly the huge increase in the amount of institutional and individual monies pouring into the fund, which then inhibits the fund manager's ability to maintain his or her intended objective. It's a lot easier to take on risks and invest in small cap stocks, for example, without having a huge effect on the stock price when there is little money invested in your fund; when large amounts start pouring in, the strategy of the fund must adapt. Although mutual funds may exhibit this behavior, investing strategies don't necessarily have the same inherent restrictions and thus a correlation between the past and future may be more easily argued.

                  I am conducting this analysis also based on the information provided Les Masonson's text All About Market Timing, which outlines a wide variety of market timing strategy and will be reviewed in a future post.

                  Essentially, Harding's bare-bones version of the STS boils down to this:
                  • Buy into the market on the next-to-last trading day of October
                  • Exit the market on the fourth trading day of May
                  This simple strategy echoes the popular adage, "Sell in May and go away." Harding, however, takes it one step further, using the Moving Average Convergence Divergence (MACD) indicator to fine-tune the entry and exit points. The short-term signals of the MACD that occur throughout the year are completely ignored until these certain pre-determined calendar dates. This cuts down on trading fees, simplifies the strategy, and significantly reduces the amount of time required of the investor to make such decisions (the investor only has to look at the MACD indicator during a two week or so window twice a year).

                  If a buy signal from the MACD indicator happens before the calendar date, the investor is advised to undertake a position in equities earlier. On the other hand, if the MACD is stuck on the sell signal when the date approaches, the investor is supposed to wait until the MACD finally once again indicates a buy signal. The MACD is used the same way in May, except in the opposite fashion.

                  To summarize the STS using the MACD in its simplest terms requires just two points:
                  • Buy on the first MACD buy signal on or after October 16
                  • Sell on the first MACD sell signal on or after April 20
                  That's easy, right? Does something so simple actually work?

                  Historical Results and Analysis

                  Let's backtest it and see what the results show us. Note that in the following analysis, I don't take the t-bill or cash rate into account when using the STS strategy. Thus, the STS is a significant handicap when compared to buy-and-hold since the investment is guaranteed to return 0% in the months that it's not invested in the market. So, it's not truly a fair comparison, but I wanted to see how the STS would fare under conditions that perhaps aren't equal footing (and I didn't want to have to go through the effort of looking up the t-bill rates of all these months). So, if my final results indicate that the STS outperformed buy-and-hold, this outperforming figure actually understates the degree to which STS outperformed buy-and-hold, assuming a sensible investor had taken his or her money to t-bills or cash equivalents during the non-invested period. On the other hand, if STS underperformed under certain time ranges based on my analysis, the degree to which the STS underperformed the market averages is exaggerated. The power of compounding just a couple percentage points over the course of ten years is fairly significant, so clearly, I'm not giving the STS any breaks. Let's see how his strategy does given those caveats!

                  First, let's look at how the STS performs using the S&P 500 (a low cost index fund such as VFINX or an ETF such as SPY is most appropriate) during one of the largest bull markets in American history: 1991-1999. Remember, the STS recommends buying on or after October 16, and then selling on or after April 20, depending on the MACD indicator.

                  Huge Bull - Seasonal Timing Strategy
                  Buy Date Buy Price Shares Cost Basis Sell Date
                  10/17/1991 391.92 25.52 $10,000 5/14/1992
                  10/16/1992 411.73 25.60 $10,541 4/20/1993
                  10/18/1993 468.45 24.33 $11,396 5/11/1993
                  10/17/1994 468.96 22.90 $10,740 4/20/1995
                  10/16/1995 583.03 19.85 $11,572 4/20/1996
                  10/16/1996 704.41 18.26 $12,859 5/29/1997
                  11/6/1997 938.03 16.43 $15,409 4/20/1998
                  10/16/1998 1056.42 17.47 $18,458 4/20/1999

                  Sell Price Sell Value Difference % Net Change Cumulative
                  413.14 $10,541 $541 5.4% 5.4%
                  445.1 $11,396 $854 8.1% 14.0%
                  441.49 $10,740 -$656 -5.8% 7.4%
                  505.29 $11,572 $832 7.7% 15.7%
                  647.89 $12,859 $1,287 11.1% 28.6%
                  844.08 $15,409 $2,550 19.8% 54.1%
                  1123.65 $18,458 $3,049 19.8% 84.6%
                  1306.17 $22,822 $4,364 23.6% 128.2%
                   Cumulative + 128.22%

                  Huge Bull - Buy and hold
                           Year 31-Oct 31-Oct Difference % Net Change Cumulative
                  1992 392.45 418.68 $26.23 6.68% 6.68%
                  1993 418.68 467.83 $49.15 11.74% 19.21%
                  1994 467.83 472.35 $4.52 0.97% 20.36%
                  1995 472.35 581.5 $109.15 23.11% 48.17%
                  1996 581.5 705.27 $123.77 21.28% 79.71%
                  1997 705.27 914.62 $209.35 29.68% 133.05%
                  1998 914.62 1,098.67 $184.05 20.12% 179.95%
                  1999 1,098.67 1362.93 $264.26 24.05% 247.29%
                  Cumulative + 247.29%

                  So, the STS significantly underperforms buy and hold over this period. This is not surprising since this was a period in which nearly every month the market was up, so being out of the market 50% of the time would certainly have impacts on overall return.

                  Ok, let's take a look at a relative bear market then: 1999 - December 2009.

                  Note: While this post was originally written in June 2009, I have updated it with results through December 2009.

                  Relative Bear - Seasonal Timing Strategy
                  Buy Date Buy Price Shares Cost Basis Sell Date
                  10/22/1999 1301.65 7.68 $10,000.00 4/20/2000
                  10/23/2000 1452.3 7.59 $11,020.93 5/11/2001
                  10/16/2001 1097.54 8.61 $9,452.90 4/22/2002
                  10/16/2002 860.02 11.41 $9,814.90 5/19/2003
                  10/16/2003 1050.06 10.01 $10,508.20 4/23/2004
                  10/27/2004 1125.4 10.14 $11,414.26 4/18/2005
                  10/24/2005 1199.38 9.69 $11,622.99 4/17/2006
                  10/16/2006 1369.06 9.10 $12,455.91 5/10/2007
                  11/28/2007 1469.02 9.24 $13,569.62 5/8/2008
                  10/28/2008 940.51 13.73 $12,910.64 4/22/2009
                  10/16/2009 1087.68 10.65 $11,579.64 Now

                  Sell Price Sell Value Difference % Net Change Cumulative
                  1434.54 $11,021 $1,021 10.2% 10.2%
                  1245.67 $9,453 -$1,568 -14.2% -5.5%
                  1139.57 $9,815 $362 3.8% -1.9%
                  920.77 $10,508 $693 7.1% 5.1%
                  1140.6 $11,414 $906 8.6% 14.1%
                  1145.98 $11,623 $209 1.8% 16.2%
                  1285.33 $12,456 $833 7.2% 24.6%
                  1491.47 $13,570 $1,114 8.9% 35.7%
                  1397.68 $12,911 -$659 -4.9% 29.1%
                  843.55 $11,580 -$1,331 -10.3% 15.8%
                  1102.47 $11,737 $157 1.4% 17.4%
                  Cumulative + 17.37%

                  Relative Bear - Buy and hold
                  Year 31-Oct 31-Oct Difference % Net Change Cumulative
                  2000 1362.93 1429.4 $66.47 4.88% 4.88%
                  2001 1429.4 1,059.78 -$369.62 -25.86% -22.24%
                  2002 1,059.78 885.76 -$174.02 -16.42% -35.01%
                  2003 885.76 1,050.71 $164.95 18.62% -22.91%
                  2004 1,050.71 1,130.20 $79.49 7.57% -17.08%
                  2005 1,130.20 1,207.01 $76.81 6.80% -11.44%
                  2006 1,207.01 1,377.94 $170.93 14.16% 1.10%
                  2007 1,377.94 1,549.38 $171.44 12.44% 13.68%
                  2008 1,549.38 968.75 -$580.63 -37.47% -28.92%
                  2009 968.75 1066.11 $97.36 10.05% -21.78%
                  2010 1,066.11 1,102.47 $36.36 3.41% -19.11%
                  Cumulative -19.11%

                  During a ten-year period in which the S&P 500 was down nearly 20%, the STS was up 17%, an outperformance of an impressive 37% considering this strategy is so simple. Again, that 37% understates the outperformance if the investor had chosen to put his or her assets in t-bills, cash equivalents, or even bond holdings during the periods in which he or she was out of the market.  As of June 2009, STS was outperforming buy and hold by 56% for the ten-year period, but had a dreadful 2009 while the market was bullish throughout.

                  How about combining these two markets? Taking the period of 1991 - December 2009, a period beginning with one of the largest bull markets in history and ending with one of the largest bears:

                  Huge Bull followed by relative Bear - STS
                  Buy Date Buy Price Shares Cost Basis Sell Date
                  10/17/1991 391.92 25.52 $10,000 5/14/1992
                  10/16/1992 411.73 25.60 $10,541 4/20/1993
                  10/18/1993 468.45 24.33 $11,396 5/11/1993
                  10/17/1994 468.96 22.90 $10,740 4/20/1995
                  10/16/1995 583.03 19.85 $11,572 4/20/1996
                  10/16/1996 704.41 18.26 $12,859 5/29/1997
                  11/6/1997 938.03 16.43 $15,409 4/20/1998
                  10/16/1998 1056.42 17.47 $18,458 4/20/1999
                  10/22/1999 1301.65 17.53 $22,822 4/20/2000
                  10/23/2000 1452.3 17.32 $25,152 5/11/2001
                  10/16/2001 1097.54 19.66 $21,573 4/22/2002
                  10/16/2002 860.02 26.05 $22,400 5/19/2003
                  10/16/2003 1050.06 22.84 $23,982 4/23/2004
                  10/27/2004 1125.4 23.15 $26,050 4/18/2005
                  10/24/2005 1199.38 22.12 $26,526 4/17/2006
                  10/16/2006 1369.06 20.76 $28,427 5/10/2007
                  11/28/2007 1469.02 21.08 $30,969 5/8/2008
                  10/28/2008 940.51 31.33 $29,465 4/22/2009
                  10/16/2009 1087.68 24.24 $26,363 Now

                  Sell Price Sell Value Difference % Net Change Cumulative
                  413.14 $10,541 $541 5.4% 5.4%
                  445.1 $11,396 $854 8.1% 14.0%
                  441.49 $10,740 -$656 -5.8% 7.4%
                  505.29 $11,572 $832 7.7% 15.7%
                  647.89 $12,859 $1,287 11.1% 28.6%
                  844.08 $15,409 $2,550 19.8% 54.1%
                  1123.65 $18,458 $3,049 19.8% 84.6%
                  1306.17 $22,822 $4,364 23.6% 128.2%
                  1434.54 $25,152 $2,330 10.2% 151.5%
                  1245.67 $21,573 -$3,579 -14.2% 115.7%
                  1139.57 $22,400 $826 3.8% 124.0%
                  920.77 $23,982 $1,582 7.1% 139.8%
                  1140.6 $26,050 $2,068 8.6% 160.5%
                  1145.98 $26,526 $476 1.8% 165.3%
                  1285.33 $28,427 $1,901 7.2% 184.3%
                  1491.47 $30,969 $2,542 8.9% 209.7%
                  1397.68 $29,465 -$1,504 -4.9% 194.6%
                  841.5 $26,363 -$3,102 -10.5% 163.6%
                  1102.47 $26,721 $358 1.4% 167.2%

                  Cumulative + 167.21%

                  Huge Bull followed by relative Bear - Buy and hold
                  Year 31-Oct 31-Oct Difference % Net Change Cumulative
                  1992 392.45 418.68 $26.23 6.68% 6.68%
                  1993 418.68 467.83 $49.15 11.74% 19.21%
                  1994 467.83 472.35 $4.52 0.97% 20.36%
                  1995 472.35 581.5 $109.15 23.11% 48.17%
                  1996 581.5 705.27 $123.77 21.28% 79.71%
                  1997 705.27 914.62 $209.35 29.68% 133.05%
                  1998 914.62 1,098.67 $184.05 20.12% 179.95%
                  1999 1,098.67 1362.93 $264.26 24.05% 247.29%
                  2000 1362.93 1429.4 $66.47 4.88% 264.22%
                  2001 1429.4 1,059.78 -$369.62 -25.86% 170.04%
                  2002 1,059.78 885.76 -$174.02 -16.42% 125.70%
                  2003 885.76 1,050.71 $164.95 18.62% 167.73%
                  2004 1,050.71 1,130.20 $79.49 7.57% 187.99%
                  2005 1,130.20 1,207.01 $76.81 6.80% 207.56%
                  2006 1,207.01 1,377.94 $170.93 14.16% 251.11%
                  2007 1,377.94 1,549.38 $171.44 12.44% 294.80%
                  2008 1,549.38 968.75 -$580.63 -37.47% 146.85%
                  2009 968.75 1066.11 $97.36 10.05% 171.65%
                  2010 1,066.11 1,102.47 $36.36 3.41% 180.92%
                  Cumulative + 180.92%

                  The STS and buy and hold performed approximately the same over this period (again, the STS probably would have been about equal or even slightly above the S&P 500 as opposed to -13% if t-bill rates were considered). Also note that one might also consider the tax ramifications of buying and selling twice a year as opposed to holding positions over a significant period of time. This analysis does not take the tax benefits (writing off losses) or downfalls (short-term income tax as opposed to capital gains tax) into account.

                  I also did this analysis with an even more simple market timing strategy - simply avoiding the market each September and October, the two months that historically have performed the worst and have been the period in which significant pullbacks occurred most frequently. Following is a graphical representation of the cumulative performance of buy and hold, STS, and avoiding September and October.

                  Source: Self

                  Blue = STS; Green = Sept and Oct avoidance; Red = Buy and hold

                  As you can see, buy and hold is more volatile than either timing strategy, but all three end up at about the same place. Market timing is actually a conservative strategy. This is logical since you are out of the market for a significant portion of the year. Buy and hold was significantly better during the bull market of 1991-1999, but gave up almost all its gains in the following years. It you can't stomach the ups and downs, a market timing strategy might actually make more sense for you. You just have to be prepared for missing some gains if a huge bull is just around the corner. It's also interesting to note in the above graph that the STS and September and October avoidance strategically are quite similar.

                  Source: Self

                  Looking at a relative bear, you can see that STS outperforms both other strategies fairly significantly. Again, this is understated due to the caveat explained above. It's quite remarkable really thatthe STS is that even remotely reliable at capturing the majority of the market gains, while avoiding the market before it turns sour.

                  Finally, here is a year-by-year analyis of the three strategies.

                  Source: Self

                  Again, this re-affirms the conclusion that buy and hold is more volatile, while the timing strategies moderate both the yearly gains and losses.

                  Here's a chart summarizing the performance of the three strategies:

                  Strategy 1991 - 2009 1999 - 2009
                  STS +167.2% +17.4%
                  Buy and hold +180.9% -19.1%
                  S&O Avoid +188.2% -6.5%

                  In 2009 (as of 12/21/09 close), STS is down about 8% (perhaps the worst on record), while buy-and-hold isup a whopping 18.3%! Avoiding September and October is also up 15.8%. You can see Sy Harding's defense of the STS despite its 2009 performance here. He argues that the seasonality phenomenon still typically occurs; however, cases in which excess liquidity floods the market, like what happened in 2003 and 2008, have even greater consequences than the seasonality. Harding cites a study that explored the results from 1926 - 2006 and concluded that the seasonality patterns are robust over time and not likely data mining. In any event, it's certainly interesting to hear his perspective and respond to the criticism of this year's performance. It's clear that he has purposefully neglected to update his own website with the 2009 results in an effort to not broadcast them.


                  Finally, here are some summary points based on this analysis:
                  1. During continuous bull markets, market timing will always lag buy and hold. While STS has shown to be able to capture most of the upside of the market, being out of the market around 50% of the year subjects your money to missing significant gains during continuous bull markets. This isn't unique to STS and all market timing strategies will underperform during huge bull markets - this is just a fact.
                  2. Market timing is a conservative strategy. If you want to reduce risk, perhaps timing the market (with sound, systematic strategies and not emotion) is for you. Since exposure to the market is cut by about half, during bear markets these strategies offer significant protection against the downside.
                  3. STS has historically been able to avoid the worse downturns. On the flip side, of course, is that while it captures the majority of the gains, it certainly misses out on some of them as well. Since 1999, STS is up 17%, while the S&P is down 19%, for an impressive 36% outperformance based on a simple strategy.
                  I'll admit that I was a skeptic of market timing before this procedure.  After reading various articles, texts, and performing my own individual analysis, I still think that the vast majority of people are best served by dollar-cost averaging into a low-cost index fund over time. However, my perspective has changed a bit, and I think that a simple market timing strategy (such as the STS) can be a sensible approach for a small segment of the population that hope to use a risk-reducing strategy. As they say, past performance is no guarantee of future results and those employing this strategy should not expect outperformance over the long-term similar to what occurred during the past 10-year bear market.  But it appears this seasonality affect does moderate volatility a bit.  An even simpler (and typically preferable) method to reduce risk would be to simply increase one's bond allocation.
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