Introduction to Stocks Introduction to Stocks DecalDecalLecture 11: Active & Passive Management, Indexing, and Portfolio Construction

Spring 2008Lawrence Wu

CURRENT EVENTSCURRENT EVENTSApril 15, 2008 – April 22, 2008

Quote of the WeekQuote of the Week"The takeaway from that is that

the news is still bad, but it's not catastrophic," said Claire Gruppo, the co-founder of the boutique investment bank Gruppo, Levey & Co. "There's an underlying fear factor that it's going to be an unmitigated disaster. So when it just continued to be pretty bad, there's a 'phew' factor."

LECTURELECTURE

OutlineOutlineSimulation winnerRiskIndex funds The ExpertsInvesting PrinciplesPortfolio Considerations

RiskRisk Two kinds of risk

◦ Systematic and Idiosyncratic or…◦ Market risk vs. diversifiable risk

Market risk cannot be eliminated (otherwise you wouldn’t be in the market)◦ You are compensated for taking on this kind of risk

Diversifiable risk◦ Company, sector, political, currency etc.◦ Company risk can be eliminated by investing in a

large number of companies Groups of stocks provide the same

expected return with lower risk Rational investors: Reject individual stocks in

favor of a well-diversified group of stocks (unless you feel like you can pick the right individual stocks)

What does history tell usWhat does history tell us

Source: Berk and DeMarzo. Corporate Finance.

INDEXINGINDEXING

Introduction to indexingIntroduction to indexingAn index is a group of securities

chosen to represent a marketAn index fund mimics an indexTry to minimize expected

tracking errorBest indexes don’t necessarily

provide the highest return but the one that tracks closest to the benchmark

Positive-sum gamePositive-sum gameInvesting is a positive sum gameCompounded annual return of U.S.

large cap stocks since 1926 has been 11%

Long-run return > time value of money (interest rates) is a reward for risk – represents the new wealth in society created by investment in infrastructure, research, buildings, technology etc…

Zero-sum gameZero-sum gameA game in which all profits sum to zeroHoldings of all investors in a market (i.e.

US) aggregates to form the market (Sharpe, 1991)

Active investing is zero-sum gameBecause all investors’ holdings are

represented, if one investor’s dollars outperform the aggregate market, another investor’s dollars must underperform so that the sum equal the performance of the market (which historically is a positive sum)

Sports betting and gambling are also zero-sum games

Passive vs. Active Passive vs. Active ManagementManagementPassive investor – Bob – hold every

security in the market◦ If Security B represents 5% of the market,

John will hold 5% of his portfolio in BActive investor – Harry – his portfolio

will be different than John’s at some or all times◦The active managers act on “perceptions

of mispricing,” and these perceptions change relatively often, these managers trade often, “hence the term ‘active’”

*Source: Sharpe, The Arithmetic of Active Management

Distribution of Market Distribution of Market ReturnsReturns

Blue bell curve – all investors’ returns

Blue dotted line – average market return

Gray and red – after impact of expenses and taxes

White area – fewer dollars exceed benchmark

Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 4

After cost distribution of After cost distribution of mutual fund returnsmutual fund returns

Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 6

Useful terminologyUseful terminologyAlpha - portfolio’s risk-adjusted

excess return vs. it’s benchmarkBeta - measure of magnitude of a

portfolio’s past share price fluctuations in relation to the market’s volatility

Indexing’s advantageIndexing’s advantageLower costsMore tax efficient – IRS defines a trade as

a “taxable event” – capital gains taxes are due every year stocks are bought and sold

Minimizing costs is the key to achieving long-term success◦ Every dollar paid for management fees means

$1 less in returnsResearch done on best predictor of fund

performance: past performance, Morningstar rating, alpha, and beta.*

Expense ratio was the most reliable predictor!

One of the few factors known in advance

Source: Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear

Returns vs. cost – inversely Returns vs. cost – inversely relatedrelated

Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 8

Active what?Active what?

Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 10

Individual investorsIndividual investorsIf the professionals (who spend

their livelihood) have a hard time beating the market…◦Keep in mind they don’t have to beat

the market to still make a good living because of FEES

If they can’t do it… how can you expect do it as an individual investing part-time?

TAX & RETIREMENT TAX & RETIREMENT CONCERNSCONCERNS

We’re not that old to think about retirement

Traditional vs. Retirement Traditional vs. Retirement AccountsAccountsTo help us in retirement, we have

the option of investing in special tax-deferred accounts

Grows absolutely tax freeDon’t owe Uncle Sam a dime!Depending on the tax bracket,

we’re talking about serious money here

Roth vs. Traditional IRAsRoth vs. Traditional IRAsTraditional – take tax deduction

up front, earnings aren’t taxed until its distribution after retirement◦Pay taxes when you withdraw it

Roth – contribute after-tax money, the money grows tax-free◦Pay taxes today

Roth > TraditionalRoth > Traditional1. You will likely be in a higher tax bracket

when you retire than right now as a student

2. More flexible – can withdraw early at anytime without penalty (NOT recommended – can’t put them back in later!)

3. No mandatory age-based distribution schedule – manage your own income stream after retirement

4. You contribute more with Roth - $4,000 in a Roth is worth more than pre-tax in a traditional IRA

An Example An Example 25 year old, contributes $5,000

each year into a Roth IRA until she retires, makes an annual return of 8%

She will have $1.4 million at age 65

An Example with tax An Example with tax 25 year old, contributes $5,000 each

year into a regular taxable account until she retires, makes an annual return of 8%

Taxed at 15% (assume no state tax)

She will have $1 million at age 65, $400,000 less than if she chose the Roth, down even more if there was state tax

Roth IRA Contribution Roth IRA Contribution LimitsLimitsStarting 2008, you can contribute $5,000 per year if you earn less than $99,000 (single) or $156,000 (married filing jointly)

If you are 56 years old, you can contribute $6,000 per year.

Can contribute for 2007 up tax day the following year: April 15, 2008

Roth IRA drawbacksRoth IRA drawbacksNeed taxable income to

contribute to a Roth IRA◦Can’t be income from babysitting for

mowing your neighbor’s lawn unless they reported taxes

If you wait too long, you may start earning too much making you ineligible for a Roth

The Experts

The pros weigh in.

What does Swenson say?What does Swenson say?

David Swenson, manager of the Yale endowment since 1988. The endowment earned 28 percent in its last fiscal year, which ended June 30, beating all other endowments. It finished the year with $22.5 billion

What does Buffett say?What does Buffett say?

“I believe that 98 or 99 percent — maybe more than 99 percent — of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs.” – Warren Buffett

“Wall Street makes its money on activity. You make your money on inactivity. If everybody in this room trades their portfolio around every day with every other person, you’re all going to end up broke. The intermediary is going to end up with all the money. On the other hand, if you all own stock in a group of average businesses and just sit here for fifty years, you’ll end up with a fair amount of money and your broker will be broke.” – Warren Buffett

“We think we [Berkshire Hathaway] can do better than the S&P. I would be disappointed if our portfolio didn't do a couple of percentage points better. I would be amazed if it did better.” – Warren Buffett

Warren Buffett, the greatest investor that ever lived, supports indexing.

Investing Principles

Time-tested investment principles to live by.

Some Investing PrinciplesSome Investing PrinciplesWall Street will spend over $10B in

advertising revenue to focus on buying the latest hot stock or the best mutual fund and ignore these 3 principles

1.Don’t put all your eggs in one basket.

2.There is no such thing as a free lunch.

3.Save.

1. 1. Don’t Put all your Eggs in One Don’t Put all your Eggs in One Basket Basket Diversify into different asset

classesTop 10 funds in the hottest 2

sectors does not mean diversification

Instead of trying to time the hot sectors, own ALL of them

2. 2. There’s no such thing as a There’s no such thing as a free lunchfree lunchWall Street will try to get you to “beat the

market” – more trades, transactions and profits for them, not you

Capturing more than the entire return of an asset class (what Wall street wants you to think)

Capturing the entire return of the market using low cost, tax efficient index funds

Extremely difficult to beat the market in the long term

For serious investors, the question is not, "Can I beat the market?", but rather, "How can I limit if not totally eliminate the risk of 'underperforming' the market?"

3. Save3. SaveDevelop a long-term financial

planIgnore the things outside our

control (stock prices, earnings reports etc.) and focus on what you can control: saving and spending habits

Rule of thumb: save 10% of what you earn

Portfolio Considerations

Things to consider when building your first portfolio.

Asset AllocationAsset AllocationOnce you’ve

determined your split between stocks/bonds…◦ Pick broadly diversified

funds (Total Market funds) – easier to manage

◦ “Slice and Dice” using sub-asset class funds (Large Cap Growth, Small Cap Value…)

International exposure◦ Experts recommend 20-

40% of your equity holdings in international

A 60/40 asset allocation example

Stocks & BondsStocks & Bonds Max Equity - Exposure Max loss

20%..............................5% 30%.............................10% 40%.............................15% 50%.............................20% 60%.............................25% 70%.............................30% 80%.............................35% 90%.............................40% 100%...........................50%

Other ways of determining asset allocation: Your age in bonds. So, if you are 40 years old, then

use a 60/40 (equity/bond) allocation. 110 minus your age = equities (110-40 yrs old=70/30

asset allocation) 120 minus your age = equities (120-40 yrs old =

80/20 asset allocation)

How much International How much International exposure? exposure? 70% U.S./30% Int = highest

return 80% U.S./20% Int = lowest

standard deviation 1% to 40% = Int allocations that

have historically increased return over an all U.S. portfolio without increasing standard deviation

Portfolio ConstructionPortfolio Construction

1. Basically, you want to invest as much as possible in tax-deferred accounts

2. Put the most tax-inefficient investment products in tax-deferred accounts

3. Use only tax-efficient funds in taxable accounts

Open a Roth IRA now!

Mock Portfolio #1Mock Portfolio #1For us 20+ year olds:100% - Vanguard 2050 Target

Retirement Fund◦72% - Total stock market◦10% - Bonds ◦18% - International

Auto-rebalancing as you age – shift from stocks to bonds as you grow older

Boring but simple and it works

Portfolio ConsiderationsPortfolio ConsiderationsTotal stock market index provides

maximum diversification and tax-efficiency – should make up the core of portfolio (50%)

Add foreign stocks for international exposure (10-40%)

Small-cap value stocks have historically outperformed, very tax-inefficient (5-10%)◦Keep it in a tax-deferred account (Roth IRA)

Add other asset classes like real estate or commodities (5%)

Index funds or ETFsIndex funds or ETFsYou can either buy index funds

directly from the mutual fund company or open a brokerage at Zecco and buy ETFs

Vanguard generally has the lowest fees, Fidelity is okay

I’d recommend index funds only because you’re more likely to stick to the plan… with Zecco you might be tempted to overtrade (free trades!)

Mock Portfolio #2Mock Portfolio #250% Total Stock Market

◦ VTI, IWV, VTSMX30% Total International

◦ EFA, EEM, VEU, VGTSX10% Bonds

◦ VBMFX, BND5% Small-cap value

◦ IJS, VBR, VISVX5% REIT

◦ RWR, VGSIX, VNQCompare expense ratios on

prospective funds

SOME LAST MINUTE SOME LAST MINUTE ADMINISTRATIVE ADMINISTRATIVE POINTSPOINTS

Extra readingExtra readingResearch papers on this subject

if you’re interested:Sharpe – The Arithmetic of Active

Management◦Won the 1990 Nobel Prize in

Economics for developing CAPMThorley – The Inefficient Market

Argument for Passive Investing

Sharpe

Thorley

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““Office Hours”Office Hours”Portfolio helpAnalyzing your current holdingsE-mail me if you have any

questions, I’ll hold “office hours” at 4:00pm at Café Strada next Wednesday (4/29)