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Discover key mistakes individual investors make, traditional retirement strategies, and the rational approach to managing risk. Learn about micro investing mistakes, the Hedge Fund Phenomenon, and how mutual funds can provide a viable solution.
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The New Rules of Investing for Retirement Bob Carlson Editor, Retirement Watch AAII February 2006 800-552-1152 www.RetirementWatch.com
The Investment Battle The Windshield vs. The Bug
The 7% Club • Individual investors earn lower • returns than they should. • Most losses are due to key • mistakes. • Mistakes are both macro and • micro.
Micro Investing Mistakes • Asking the wrong question • Investing with a rearview • mirror • Following the ratings • Not building a portfolio
Traditional Investment Strategies • Investing for Income (being • conservative) • Holding stocks for the long run • Using the “policy portfolio”
The Policy Portfolio Determine return goal Determine level of risk (volatility) Pick diversified, efficient portfolio — index funds Hold portfolio for the long term
Problems with CAPM • Volatility is not risk • Real risk is goals are not achieved • Few investors can ignore the short and intermediate term • Bear markets can last 10 years or longer
Problems with CAPM • Markets not always efficient • Past patterns don’t always continue — Remember LTCM • “Diversified” portfolios usually are correlated to stocks • “Utterly naïve” “utterly unrealistic” — Martin Whitman
Problems with CAPM Source: T. Rowe Price
Rational Investing: Risk Management • Markets are not always efficient and rational • Investors are rational but not necessarily right or in agreement • Results in valuation cycles for all assets
Rational Investing: Risk Management • Optimists vs. pessimists determine the markets — expectations of returns • Consensus views tend to persist for a long time • Consensus at the extremes usually is wrong • Cycles are the biggest risk to investors
Rational Investing • The very long-term is not the way to manage money • Risk is uncertainty. It must be managed. • Managing the valuation cycle is key to managing risk • A margin of safety is essential
Rational Investing in Action • The Core Portfolio • Always have a fixed, diversified, balanced portfolio • Always in the markets. Avoids overtrading, trend following • Value-oriented funds in the Core Portfolio
Rational Investing in Action • The Managed Portfolio • Manage the investment cycles and their risk • Not short-term trading; one- to three-year outlook • Primary goal is to reduce risk; eliminate high risk assets • Combine valuations with market and economic trends
Micro Investing Mistakes • Using the economy and earnings • to adjust portfolios • Taking big risks to earn high • returns • Using automatic investment • signals; being fooled by • randomness • Confusing beta and alpha
Where Are We Now? Source: Ned Davis Research
Falling Valuations 2/1/991/26/06Change S&P 500 1273 1273 0% S&P 500 EPS$44.49 $74.02 66% S&P 500 P/E28.4 17.2 -39%
Where Are We Now? • Few values and opportunities worldwide • Likely in an era of below-average returns • U.S. stocks neither undervalued nor overvalued • Pockets of opportunity in U.S. stocks
Where Are We Now? • International and emerging market stocks better values than U.S. stocks • U.S. real estate is fairly valued to modestly overvalued • Commodities probably still a good opportunity • Few opportunities in bond markets
The Hedge Fund Phenomenon • Trillions of dollars of flowed into hedge funds since 2000 • Believed to be over 6,000 hedge funds • Investment talent flowing into hedge funds • Initially for wealthy, institutions
The Hedge Fund Phenomenon • Investors seek: Absolute returns, more • predictable returns • Reduced risk, volatility • Low correlation with major • market indexes
Disadvantages of Hedge Funds • Difficult to evaluate • Little transparency, low regulation/accountability • Low liquidity • High fees
Disadvantages of Hedge Funds • Potential volatility • Low capacity, most of the best funds closed • Too many funds chasing the same strategies • Great variability; not a real asset class
The Mutual Fund Solution • A number of mutual funds use “hedge fund” or alternative strategies • Open to all investors • Lower cost • Daily liquidity
The Mutual Fund Solution • Transparent investments, easier to evaluate • Low correlation with major markets • High long-term returns • Best funds have limited capacity, closed to new investors
The “Hedge Fund” Portfolio • A portfolio of no-load, low expense mutual funds • Funds have low correlation to major market indexes • Funds have low correlation with each other • Use traditional “hedge fund” strategies
The “Hedge Fund” Portfolio • Portfolio achieves long-term returns similar to stock indexes with less volatility • Buy-and-hold portfolio • Will lag in bull markets
Mutual Fund “Hedge Funds” • Core “hedge funds”: • Hussman Strategic Growth • Pimco All Asset • Leuthold Core Investment • Long/Short Equity • Laudus Rosenberg Global • Long/Short Equity
Mutual Fund “Hedge Funds” • Opportunity Funds • Third Avenue Value • Berwyn Income • FPA Crescent • Other funds: • High yield bonds • Cohen & Steers Realty Shares • American Century • International Bond • Oakmark Equity & Income
Hedge Fund Portfolio Returns Back-Tested Results (Last 10 Years) Alpha 5.60 Beta 0.27 Std. Deviation 6.46 Worst Quarter -9.54% Best Quarter 10.84%