The Full Motley: 2012 Preview

On December 31, 2011, the market closed the year at 12,217.56, which was approximately 6% up for the year (opening at 11,577.51).  This news made me happy because all year, I had said that the 2011 markets would be up <10%.  Believe me, there were times when I thought I would be off.  More often than not, I expected that the markets would close higher than 10% but a surprisingly slow fourth quarter dashed those higher expectation.  Interestingly, the second and third quarters had most analysts forecasting a down year but, as often the case when taking current news and projecting it too far into the future, their predictions were short-sighted.  The best success is when projecting far into the future, at least a year.  That said, those expectations will not always prove to be true, but they remove emotion from investing, which is often the most common pitfall to trip up investors.

Case in point, my predictions last year were that the stock market would be up less than 10% (as measured by the Dow) and that bonds and gold would suffer great falls.  Additionally, I added an actively managed fund to my portfolio to hedge against the perceived lag of indexing.  As already noted, I was right about the markets going up between 0-10%, but my other expectations were incorrect.

The 12-month return in the Vanguard Total Stock Market Index (Investor Shares) was 0.96% whereas the returns for the PRIMECAP Fund retreated by -1.84%.  This is a testament to the strength of indexing since PRIMECAP is one of the most highly regarded actively managed funds Vanguard has to offer.  Additionally, the Vanguard Total Bond Market Index (Investor Shares) returned 7.56% in the year that I expected bonds to fall significantly.

The following are the 2011 returns for funds in which I am invested or in which I have been invested in the past five years listed from highest (bonds) to lowest return (international):

• GNMA Fund Inv 7.69%
• Total Bond Mkt Index Inv 7.56% (Adm 7.69%)
• High-Yield Corp Fund Inv 7.13
• 500 Index Fund Inv 1.97
• Total Stock Mkt Idx Inv 0.96% (Adm 1.08%)
• STAR Fund 0.77%
• Prime Money Mkt Fund 0.05%
• PRIMECAP Fund Inv -1.84%
• Explorer Fund Inv -1.89%
• Total Intl Stock Ix Inv -14.56%

At this point in the year is when I like to set my strategy for the coming year.  While the Presidential Election adds a great degree of uncertainty to American investors, I recently read that the market is usually positive during election years.  As a result, I am not going to make any changes to my current allocation and maintain my current investment strategy.

As for the market itself, I expect that the Dow will be up over 10% and close above 13,439.32 in 2012.

Experimental Fund

One of my favorite films (easily, Top 5) is "American Beauty."  The tagline for the film was "Look closer."  It rings as a periodic reminder each time I am asked for my thoughts on a specific investment.  Whenever someone asks my thoughts, my first question is never "how much are you putting in it?"  Amounts are always relative.  My first question is "will the amount you're putting in the investment be more than 5% of your overall balance?"  If the answer is no, then I often encourage the investment with a mindful eye.

One term I learned from listening to Mo Ansari over the years is "exit strategy."  When I left my last job, I formulated my exit strategy for almost 15 months before my actual departure.  However, a job is not an investment (at least, not in these terms) and formulating an exit strategy at that point would have been heavily delayed.  The best exit strategy is formed before you invest.  And it is written.  In case you haven't noticed, a lot of this blog has been written for my own use to remember what I was thinking at the time I made specific moves.

If you invest in a fund, you should know your tolerance for its success and its failure.  "If the fund raises above 20%, immediately remove the gains."  "If the fund falls 20%, immediately sell the position."  Those are examples of flawed exit strategies.  They lack a relative basis.  The last time I added a new position to my portfolio, my exit strategy was to sell out if the fund under-performed the relative index fund for two consecutive years.  The markets could gain or lose 20% in a given year, and it is not a reflection on the investment.  Every investment has an opportunity cost, and that is the true measure for its success or failure.

For example, invest 2% of your bond index fund into a GNMA fund.  The opportunity cost is measured by the performance of that bond index fund, because this money would be doing better or worse if you had left it in that investment.  The true performance for your GNMA Fund would based on that bond index fund.

This complex mentality will block you from making three critical errors.  First, you will never move your stock funds to a bond.  The basis for comparison will be impossible to track (or more effort than it's worth).  Second, the fund will have an established second home.  If your fund is under-performing against your original expectations, then your exit strategy innately moves it to its base.  Whether you invest in another experimental fund immediately thereafter is another story, but at least you will not stay on the fence with that experiment's conclusion.  There is no agonizing over the conflicting thoughts of "it could move back up (yes, it could) but it could keep falling (also true)."  Finally, your expectations will not fluctuate like your emotions.  If you consider today what you think the market will do in 2012, but you do not write it down, then chances are your memory of today's expectations will be significantly different than what they will be when you recite them in December 2012.  This is because emotions affect our expectations.

(to be continued... ??)

We Believes

During my time at Vanguard, I worked in our institutional processing department for six years.  We had minimal interaction with investors, and as a result, many people in our department were not aware of the specifics of investing.  Fortunately, I worked in the retail customer service department for several years beforehand, so I came into the department with sufficient exposure.

After the markets crashed in late-2008, a friend from the retail side and I were eating lunch and he mentioned the bore of reciting Vanguard's investment philosophy to every caller.  The irony was that I had not thought about it since I left that division, and the more thought I gave it, the more I felt people in my new department should be aware of our company's investment beliefs.  Therefore, I created a Powerpoint to present the concept to them in an abbreviated fashion.

Vanguard is a solid investment company, anchored by these sound strategies and beliefs.  Some are how to succeed and some are how to not fail, but each of them is worth considering (and in the case of his entry, sharing) and I always appreciated the fact that it was never referred to as their "creed."

We Believe:

• Investing is for meeting long-term goals; saving is better for short-term goals: Money that investors may need in the short-term (two years or less) should be kept in short-term investments which protect capital. These include money market funds (a fund that invests in short-term financial instruments such as cash), bank accounts, or government bonds (Gilts). Clients should only consider investments in the stock market or corporate bonds when they have money to put away to help meet a longer-term objective.
• Broad diversification, with exposure to all parts of the stock and bond markets, reduces risk: If an investment portfolio does not fairly reflect the overall investment market in terms of balanced asset allocation (the process of dividing investments amongst different asset classes such as stocks, bonds and cash) and investment style (such as growth or value), we believe clients are taking additional risk. We judge that this is unlikely to pay off over the long term.
• An investor's most important decision is selecting the mix of assets to be held in a portfolio, not selecting the individual investments themselves: Deciding on the mix and proportion of stocks, bonds, and cash in a portfolio is critically important - much more so than deciding on individual assets or funds. To work out the asset allocation that's best for each individual, investors need to consider factors such as their financial needs, their tolerance of risk and the length of time they want to invest.
• Consistently outperforming the financial markets is extremely difficult: Economic uncertainties, random market movements, and the rise and fall of individual companies mean it is extremely difficult for anyone - including professional investors - to beat the market in the long term. An active manager buys or sells shares (or bonds) in order to meet a particular investment objective. Therefore, typically actively managed funds have higher operating and transaction costs which can eat into returns. So we believe it makes sense to begin by considering funds that follow an index.
• Minimizing cost is vital for long-term investment success: Costs matter a great deal because investment returns are reduced pound for pound by the fees, commissions, transaction expenses and any taxes incurred. Investors as a group earn somewhat less than the market return after subtracting all those costs. Therefore, by minimizing costs, investors improve their odds of meeting their investment objectives.
• Investors should know how each investment fits into their plans, and why they own that particular asset: Investors need to be clear why they own each particular investment. Knowing the characteristics of each investment and the role it plays in a diversified portfolio increases investors' chances of selecting suitable investments that can be held for the long term.
  Risk has many dimensions and investors should weigh 'shortfall risk' - the possibility that a portfolio will fail to meet longer-term financial goals - against 'market risk', or the chance that returns will fluctuate.
  In the long run, what matters most is whether your investments enable you to meet your objectives. Earning enough to meet objectives is much more important than whether investments suffer interim declines or trail a market benchmark. But many investors react only to market risk. They may bulk up on stocks when markets are doing well, taking on more market risk than they realize. Conversely, they're tempted to reduce allocations to stocks in response to market downturns. In truth, to achieve long range goals, most investors need to accept some level of risk from equities.
• Market-timing and performance-chasing are losing strategies: Market-timers who buy and sell frequently, hoping to 'catch the wave' as securities rise and fall, need to be very sure that their timing is right. Otherwise, they stand to lose money from market movements while also paying significant transaction costs. As many investors say: it's time in the markets that counts, not timing the markets. Also, market fashions change - often very suddenly. There is no guarantee that a performance-chasing strategy, asset class (a type of investment such as stocks, bonds or cash), or fund that has performed well will continue to perform well next year, next month - or even tomorrow.
• An investor should not expect future long-term returns to be significantly higher or lower than long-term historical returns for various asset classes and sub-classes: The major asset classes (equities, bonds, cash investments) have long histories and well established risk/reward characteristics. When estimating future returns for asset classes or sub-asset classes, long-term historical returns are a good place to start. Vanguard expects that returns from various sub-classes of the stock market will be similar to each other over long periods. Also, Vanguard expects that the long-term return for equities will be higher than that for bonds, and that bond returns will, in turn, exceed returns on cash investments over long periods.

Investors should always remember that no method for predicting market returns is perfect. Past performance is not indicative of future results.  Contrariwise, "you have to stand for something or else you'll fall for anything."  That is especially true when it comes to a fool and his money.

A lot of this article was reprinted from Vanguard.com

Investing 101

This evening I had a lengthy, perhaps unproductive conversation with my best friend about investing.  She wants to have a nest egg for the future.  She also does not want to spend all of the money that she has recently been able to acquire.  Most importantly, she knows she is interested in investing, not just saving.  Unfortunately, she does not know a lot about investing, but I gave her a quick crash course.

STOCKSWe talk about stocks all the time that as often as not the exact definition and even the concept can escape us.  Just to clarify, stock are slices of ownership in a corporation.  The ownership is split among thousands of investors, so the ownership is less than 1% of the company, but the performance of the stock reflects the success of the company, so if the company is turning a beautiful profit, your stock should reflect your proportion of ownership in the form of a dividend.  Stocks pay dividends quarterly (sometimes less often like semi-annually or annually) to their owners.

Unfortunately, if a company is trading at $10/share, then investing only $100 to buy 10 shares is counter-productive (transaction costs alone would eliminate profits), so you would have to invest $1,000 to buy 100 shares and even then, you would only have shares in one company.  At that rate, you would need at least $10,000 to invest in 10 different companies in order to maintain any adequate portfolio, and even then, ten companies is not a lot if you were investing strictly in stocks.

Therefore, I classify stocks as a rich-man's game.  There are exceptions to that classification, and E*trade insists that everyone from smart-ass toddlers to their butlers should participate.  Personally, I disagree.

BONDS
Whereas stocks are ownership in a corporation, bonds are the antithesis.  They are company-issued debt.  If a company needs an influx of cash, they will offer a 10-year bond (for example) and they would pay interest monthly on the bond, then pay the principal of the bond at maturity.  While stocks fluctuate greatly with the success of the company to which it is associated, bonds have no variation.  Therefore, they are a far more stable investment.

However, buying bonds has the same issue as above.  If it is a $10,000 bond, then an investor would put the $10,000 out first, and then it would build.  In the bond market, the price may trade below (or even above) the face value of the bond itself in which case terms like "premium" and "discount" come into play, but to keep it simple, a bond is company debt repaid at a later date and you benefit from monthly (sometimes quarterly) interest.  The interest payments in bonds are similar to dividends in stocks.

MUTUAL FUND
The downside to both investments is that it requires a lot of money to begin investing.  This deterrent would prevent several hundred thousands of people from investing if not for a mutual fund.  A mutual fund was once defined to me as an investment vehicle where a group of people pool their money to invest in the stock market with the benefit of diversification and professional management, neither of which they could achieve individually.

Instead of an individual coming up with $10,000 to buy 10 stocks of 10 corporations trading at $10/share, a group can achieve this same feat and, even better, they can easily surpass those numbers.  Mutual funds allow an individual to achieve genuine market diversification through a relatively small investment.  In terms of which stocks to buy and when to sell them, each fund has a professional money manager to make those decisions to the otherwise uninformed shareholders.

The best benefit of mutual funds is their flexibility in terms of starting costs.  While stocks trade at specific prices per share, and investors can only purchase whole shares, mutual funds can sell fractions of shares.  Therefore, if a mutual fund were trading at $10, an investor could buy 12 and a half shares for $125.  Although most investors undervalue this benefit, the beauty comes in with simplified reinvestment when the fund pays dividends.

INDEX FUND
As you may have guessed, professional management is not cheap.  Mutual funds have many fees, sometimes called loads such as "front-end loads," to pay the professionals for their expertise and effort.  Obviously, this is a sweet deal for the money manager but it adversely affects shareholders, especially since the market is too unpredictable and mutual funds require daily attention to the point that money managers do not add as much value to the fund as investors may suspect.

The idea is to "beat the market," i.e. earn returns in excess of the growth of the economy (or losses less than the market declines), but only half of the money managers succeed, and when they succeed, it is usually not by a substantial amount.  Therefore, John Bogle ascertained that a mutual fund could seek to match the performance of the markets and it would not need professional management.  This theory turned into the first index fund and John Bogle later founded The Vanguard Group, where I was employed for most of the past 10 years.

BALANCED FUND
Another type of investment vehicle combines all the aforementioned vehicles.  It is a balanced fund, and they can be issued in a number of ways.  It could be a mutual fund that invests strictly in other mutual funds (e.g. "fund of funds").  If those funds include bond funds (which buy numerous bonds and replace those bonds when other bonds mature), then it would be a balanced fund.  The balanced fund may invest in index funds exclusively.

The benefit of a balanced fund (whether it is indexed or not) is that its focus is on the allocation.  If it's allocation is 70% stock and 30% bonds, then it is going to re-balance daily.  Throughout this blog, I expressed the importance of asset allocation and periodic re-balancing.

MY FAVORITE INVESTMENT
Now that we have all those terms defined, it seems that this new information should be put to some use. Therefore, I figured I could share my single favorite investment and explain why it is my favorite. It is the Vanguard STAR Fund, which is an actively managed balanced fund. The term "actively managed" means it is not an index fund. The mutual fund invests in 11 other mutual funds (all held by Vanguard) so it has exposure to stocks (60%) and bonds (40%) through 20 independently managed sub-portfolios with different yet complementary investment strategies. Also, it has a minimum initial investment of $1,000 (the average at Vanguard is $3,000).

But the real reason this fund is my favorite is that it puts the principles of a solid investment allocation first, and its returns are far less volatile than investments strictly in stocks or strictly in bonds. I never appreciated how useful this discipline was until I saw comparisons of hypothetical investments of $10,000 over the course of 10 years for this fund, compared to the Vanguard Total Stock Market Index Fund and the Vanguard Total Bond Market Index Fund. The difference was astounding because when the markets went up, this fund went up. When the markets went down, this fund went down. Contrasted mostly against the Vanguard Total Stock Market Index Fund, its declines were not nearly as drastic yet its gains seemed to be on par with the index fund. In other words, it had all the upside potential while minimizing the downside risk.

I put two months salary into the STAR Fund a while back because I was curious whether, if at an arbitrary point in the unforeseeable future, my investment balance would be more or less than two months salary at my job. I call it my "Engagement Ring Fund" for obvious reasons, but the investment experiment is virtually worthless to me now since I quit my job, so the comparison is no longer a gauge of time.  Also, I've given up on finding a spouse so my arbitrary point in the unforeseeable future is irrelevant to me (P.S., please never use this blog for advice on love).

Included to the right are four charts showing the comparison of the Vanguard STAR Fund to its Total Bond Market Index Fund (Investor shares), Total Stock Market Index Fund (Investor shares), and the Prime Money Market Fund. The charts are from various 10-year periods, including January 2009, February 2009, May 2009, and November 2011.

As you may remember from personal experience or reading prior entries here, the stock markets took a sharp nosedive in late 2008, which bottomed out in March 2009. Additionally, the Tech Bubble busted in March 2000, and then the markets dropped further after September 11, 2001, reaching a bottom in November 2002 if I recall correctly.

Obviously, the Prime Money Market Fund was not phased by any of the volatility since it is a stable value fund. The Total Bond Market Index Fund went through its share of rewards and challenges over 10 years. But note the similarities in the Total Stock Market Index Fund to the STAR Fund. When things were bad, they were worse for the Total Stock Market Index Fund. When things were good, they seemed to be equally good for both funds. This is why the fund is my single favorite investment.

When I started working at Vanguard, I had a joke about the fund's name. It was STAR but, as far as we knew, it did not stand for anything. However, I suggested that the fund should be a pre-starter fund (a starter fund is the first investment selection for your portfolio) so the letters S-T-A-R represented the beginning of the word "Starter." Looking back now, I think it was a ridiculous yet valid observation.

MSN MONEY: 'Father of 401k' disowns it

Ted Benna, who three decades ago seized on an IRS loophole to transform American retirement savings, says he's proud to be "father of the 401k." He also thinks he created a monster.

The plans, which he intended to be as simple for employees as pensions, now offer too many investing options and too many opportunities to make mistakes, he says. "I would blow up the system and restart with something totally different," he told SmartMoney. "Blowing up the existing structures is the only way we can simplify them."

In 1978, when Congress passed the section of IRS code for which the plans are named, lawmakers aimed to limit the scope of cash-deferred plans being offered by some companies, but had no intent to revolutionize retirement. Benna, then the co-owner of the Johnson Companies, a benefits consultancy in suburban Philadelphia, was developing such a plan for a bank client when he happened on the idea that section 401k could allow an entirely new option.

The original 401k plans "could be explained to employees in just a minute," Benna, now 69 and semiretired himself, says. "There were two options, a guaranteed fund and an equity fund," he says. "With the guaranteed investment fund, we'd tell them this is what you will have when you retire. With the equity fund -- which was usually something like the Fidelity Magellan fund -- we'd say, you might have more, but you might have less. Most people would split their contributions 50-50 between the two."

Plans became too complicated
As the plans were embraced by employers and financial institutions, Benna says 401k's were made so complex one needed to be an investing pro to make sense of them. "Now this monster is out of control. We went to three options, then to six, then to seven, then to 15 -- it is far beyond what most participants were able to deal with," Benna says. "And I am not convinced we have added value by getting more complicated."

Better education was supposed to be the solution to intricacies of the plans, Benna says. If employees understood the options, the power of compound interest and dollar-cost averaging, and the advantages of making pretax contributions, it was believed they would do the right thing. "We're throwing tons of money away trying to teach participants how to become skilled investors -- we said, we are going to make people smart and savvy enough to make the right investment decisions, but it just hasn't worked."

Benna blames the newfound complexity on what he says was the small percentage of employees who wanted it. "What triggered this whole mess is that some of the more sophisticated participants were a pain in the butt," he says. "You'd have these troublemaker loudmouths push human resources, and say, 'Why don't we have this "flavor of the month" fund?'" These sophisticated employees are also the ones taking advantage of the education and advice being offered, he says.

Overwhelmed, employees made mistakes
The consequence of all the complexity is twofold, he says. First, employees felt they could be more active investors. "There is too strong a potential for employees to do the worst thing ever, which is moving in the wrong direction, panicking when things are bad and cashing out after they have been battered." Secondly, the current plans induce "a kind of gridlock -- employees get so overwhelmed they do not participate -- they do nothing," he says.

Education didn't work to stop employees from sabotaging their own futures, he contends, but legislation might. "We need a legislative mandate that when you change jobs, the money needs to be retained in a retirement account -- there cannot be an option of 'here's a check, you decide,'" Benna says. He also advocates mandating all employees be auto-enrolled in the plans, and that their contributions be automatically increased one percentage point per year to a maximum of 10% to 15%.

Despite these misgivings, Benna insists the plans are benefiting millions of employees. He gets rankled whenever someone suggests the workforce would be better off had the 401k never been born, noting that the pension system was more fraught that many remember. "I am not anti-defined-benefit​ plan -- in fact I sold them for decades -- they are great, but only for those who stay with the same company for 20 or 30 years."





By Jeremy Olshan vai SmartMoney.com
http://money.msn.com/retirement-plan/article.aspx?post=eb9632ff-1d35-44ad-bf77-349f8492a081

Failure Is Unlimited

I feel as though I would be remiss if I did not discuss Occupy Wall Street somewhere in this blog, so tag this entry with #OWS.

Too bad no one argued that banks were "Too big to bail."

For the past several years, the phrase "too big to fail" has been a buzzword in these shaky markets. Certain corporations, especially in the banking and insurance industries, have been granted various benefits to keep the company afloat under the guise that they are too important to our economy to risk failing. It mostly started in the fall-out of the Lehman Brothers bankruptcy, and it was deemed a necessary measure to prevent the country from falling into an extensive recession or another "Great Depression."

It has been a controversial phrase in the finance industry since the beginning, mostly because it is a blatant oxymoron. While it has arguably been a success in keeping the economy going, the inherent flaw in the concept is destructive to long-term growth. The dissenting opinion of this tactic is that if large companies are endangered, then their structure is flawed and their collapse will see several new companies emerge from the ashes. Former Federal Reserve Chairman Alan Greenspan simplified it when he said, "if they're too big to fail, they're too big."

The Occupy Wall Street movement has pushed this issue and similar issues to the forefront recently. The(se) protest(s) is (are) mostly against this tactic and other methods to protect the country's wealth, which unfortunately has translated into protecting the country's wealthiest.

The Dow Jones Industrial Average (DJIA) or "The Dow" is comprised of 30 components. By components, we mean corporations or stocks. There are more than 2300 companies actively traded on the New York Stock Exchange. The reason the Dow is cited most often is that its history dates back to May 1896, so it compares today's markets to 100 years of history in a single measure. However, the reality is that while the DJIA is the most cited index, most index funds have far more than 30 stocks in them. Case in point, the Vanguard 500 Index Fund has 500 companies, mirroring the S&P 500. When one of those companies falls from the S&P 500, it is sold from the fund and the new company entering the S&P 500 is purchased. There is a constant "out with the old, in with the new" methodology built into the index fund itself. Likewise, the Vanguard Total Stock Market Index Fund has over 3,000 companies, so the Dow is quite literally 1% of the total stock market.

Unfortunately, the exact demands of OWS have been conceptual and the protests are unclear. Personally, I had a vague idea of the issues central to the movement, but I had to research OWS at length before I could discuss it. Most recently on "Market Watch with Mo Ansari" (an often-cited radio program), there was a guest who opposed "too big to fail" methods and proposed that what our country is facing would be the "lost decades," as opposed to the singular "lost decade" (2000-2010). At the center of his discussion, though, was a pitch for a plan to balance the country's budget in 10 years. He said several other groups tackled the proverbial Rubik's Cube known as the nation's deficit, and his proposal was the only one to wipe it out in 10 years (conversely, the average of most other proposals was 40 years).

Social Security would continue, he promised, but it would be limited to the population who needed assistance, and the population who did not need the financial assistance would stop receiving the benefits. At that point, I had to wonder: where is the incentive to be a productive member of society? I stopped listening to the guest and started pondering the question for myself. I remembered when my ex-girlfriend told me that she had to pay income tax, and I was genuinely excited for her! She moved out of state and started paying all her bills herself for the first time in her life. On top of that, she was earning enough that she owed taxes at the end of the year. Every single part of that filled me with vicarious joy. She, on the other hand, was not excited.

It seems most conversations about Occupy Wall Street begin and end at this troubling concept.

What exactly was the one demand?

Since the guest on the program mentioned lost decades, it is only appropriate to debunk that misconception as well. If a mutual fund (or individual stock) were trading at $10 today and you invested $1,000, then you would obviously have 100 shares. If the fund (or stock) rose to $17 in five years and then fell to $9 two years later, but then rallied back to $10 three years after that, then it seems as though you would have the same $1,000 again from ten years ago.

Except each year, sometimes each month or each quarter, the fund (or stock) will pay a dividend. For bonds, this is the interest earned on the debt. For stocks, it is a portion of the profit paid out to the owners of the company (stockholders). If you are investing in a tax shelter, such as a 401(k) or IRA, then you are most likely reinvesting dividends. This may not apply to complex portfolios, but the assumption of reinvesting dividends is usually a safe bet.

Therefore, you spent 10 years going between $9 and $17 per share, but your $1,000 investment is substantially higher because, periodically, the fund paid dividends and put money back into itself in the form of more shares. Ten years ago, you had 100 shares trading at $10. Ten years later, you could have 125 shares trading at $10. The investment's earnings would be 0%, but your actual return would be 25%.

However, these "cumulative returns" are often overlooked. While the media is viewing the markets at a 0% return and naming it a lost decade, your wealth has grown 25% in this single investment. The first investment in my Roth IRA was on March 11, 2003, and it went into the Vanguard 500 Index Fund. Lucky for me, that day was the lowest point in the market of the year. I did not invest any more money into that particular fund (future Roth IRA contributions went into other funds) but this investment has given me a bird's eye view of cumulative returns, so trust me when I say it was not lost time for me. The only real "losers" of the Lost Decade were the people sitting on the bench and not getting into the game.

Catchphrases and hooks grab attention. Personally, where my money is and what it is doing is enough to get my attention. And I don't have to outsource that attention to the financial media. "Too big to fail" and "lost decades" are worth discussing, but they should never drive personal investment decisions. Like Mo Ansari often reminds his listeners, you have to invest based on what the markets do, not what they should do. Which is to say, the markets rarely listen to the what financial media says. Follow the market, not the media.

How The Rich Get Richer

In recent weeks, there have been a large number of financial articles written to mark the three-year anniversary of the day Lehman Brothers filed for bankruptcy.  Calling it "unexpected" news was an understatement for most finance professionals.  There were cracks in the armor, and the possibility was discussed heavily on the Friday afternoon heading into that fateful weekend, but most people in finance do not watch the market daily and they are not aware of all the news affecting the industry.

However, everyone took notice on Monday, September 15, 2008, because the Dow closed at 10,900, down 500 points in one day.  The peak of the market was in October 2007, so the markets had been on a slow decline for several months already, but this day was different because it was triggered by a specific event, one which truly shook the confidence of the most seasoned investors.  Not just investors, the rich investors.

At this point, I should define a couple insensitive terms.  The individuals I have classified as the "rich" are by no definition evil or manipulative.  Their actions were not greedy and there was no intent to harm others.  They are the individuals who have amassed wealth by various means, and one of their top financial goals is maintaining existing assets.  I would not even classify them as risk-adverse, but rather very risk-aware.  Likewise, the "poor" are by no means living on the streets.  In fact, they probably are not living paycheck-to-paycheck either.  They are educated individuals who are either uneducated on the finer points of investing or (equally likely) undisciplined on maintaining the finer points they know.

Immediately after Lehman filed for bankruptcy, the markets tumbled and tumbled, and then, they tumbled even further.  They turned around eventually, and today the markets are currently at 11,300, just about the same level where these events began.  There are thousands of explanations and theories by professionals on how and why the markets reacted the way they did, but in hindsight of three years later, I believe part of it was the quintessential tale by which the rich get richer and the poor get poorer.

The Lehman Brothers was the fourth largest investment bank in the United States at the time of its bankruptcy.  At that point, I knew the Lehman Brothers for its bond ratings because they were the most respected in the industry.  In fact, I could not even name another bond rating.  All I knew was Lehman Brothers.  The idea of the Lehman Brothers filing for bankruptcy baffled me immediately.  Ignorance was bliss.  For those in the know, it frightened them greatly.  As a result, they continued to shift their investments from stocks and bonds to money markets, the safest investment option by far.

Personally, I don't remember what the Vanguard Prime Money Market fund was yielding back in September 2008, but I would guess that it was probably a 3% yield.  It did not matter though.  The fact that investors could protect what they had without incurring further losses was the main attraction.  Indeed, those savvy investors acted correctly in their movement.

Speaking again in my defined yet generalized terms, the rich were the first to move their money because they had the most to lose.  Perhaps they were the most informed as well, or at least, they had the most informed professionals managing their investments.  At the time, I know skeptics of the purported "worst case scenario" dismissed the initial decline as "sour grapes" over the 2008 election in which Barack Obama was elected to replace the "rich"-friendly Bush on a platform of change.

Regardless, the stock markets declined at a rapid pace, falling to 8,775 by the end of the year.  Looking back now, I believe that the high net worth investors were  protecting their investments at a rapid pace, which pushed the markets down as rapidly.  The fourth quarter is often the strongest of the year, so for the markets to fall at least 3,000 points in the fourth quarter worried more than just the rich investors.

As 2009 began, I believe more of the average investors were caught up to speed.  Perhaps fueled by the advice of some wealthier neighbors, or more likely, emotionally reacting to their declines, they started to place their own money from stocks to the safer money markets.  The markets continued to fall, reaching 6,547 on March 9, 2009.  At that point, the markets inexplicably started to turn around.  The reasons why it happened at that point remain a mystery for random speculation.  And I have my own theory.

In my belief, the rich realized the probability of the markets increasing was much higher than the probability that the markets would continue to fall.  Maybe not even "much higher," but simply higher.  In fact, we can put it in terms of money, and think through it logically.  Those money markets where the rich had placed the bulk of their assets in October were offering less than 1% so stocks would only have to gain 1% to be a more profitable investment.  While it's true that the markets could have fallen from 6,500 to 5,000 or lower, that possibility is the nature of the beast.  Investors cannot escape risk.  But when money markets pay less than 1% interest, there is no incentive to be stock-adverse regardless how risk-aware you are.

The rich understood this shift.  However, the poor could not afford to lose more.  In my prior scenario, the poor had already lost 60¢ on every invested dollar.  Meanwhile, the rich shifted to a stable investment when (or before) their portfolio fell 30%.  As things changed, the poor stayed in the money markets to protect what was left but the rich risked losing their 70¢ to gain a little more.  In this case, it was a lot more!  The markets went from a low of 6,547 in March 2009 back to 10,000 a mere 7 months later.  The markets continued to climb, so once again, the rich had $1.07 on every invested dollar while the poor continued to protect the remaining 40¢ of every invested dollar.  At the end of this scenario, the rich now have three times as much as the poor for every invested dollar.  No greed, no deception, and no malicious intent were involved.

Considering the Vanguard Prime Money Market fund yields 0.03% today (not 3% but 0.03%), there is a strong likelihood that there are many people who are still protecting the 30¢ left from each dollar.  When they do venture back into stocks, they will be buying higher than the rich did when they shifted back into stocks.  And most likely, their gains will not be as phenomenal as the rise was in those 7 months of 2009.

The key to successful investing is simply to "buy low, sell high," but this cautionary tale epitomizes how investors can innocently "buy high, sell low."  To avoid this pitfall, revisit a few of the other entries in this blog, especially the quarterly updates discussing asset allocations and the importance of a periodic rebalance.  As luck would have it, I started this blog on February 10, 2009, four weeks before the infamous 6,547 closing.