Introduction to Stocks Decal

1. Introduction to Stocks Decal Lecture 11: Active & Passive Management, Indexing, and Portfolio Construction Spring 2008 Lawrence Wu

2. April 15, 2008 – April 22, 2008 Current events

3. Quote 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."

4. Lecture

5. Outline • Simulation winner • Risk • Index funds • The Experts • Investing Principles • Portfolio Considerations

6. Risk • 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)

7. What does history tell us Source: Berk and DeMarzo. Corporate Finance.

8. Indexing

9. Introduction to indexing • An index is a group of securities chosen to represent a market • An index fund mimics an index • Try to minimize expected tracking error • Best indexes don’t necessarily provide the highest return but the one that tracks closest to the benchmark

10. Positive-sum game • Investing is a positive sum game • Compounded 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…

11. Zero-sum game • A game in which all profits sum to zero • Holdings of all investors in a market (i.e. US) aggregates to form the market (Sharpe, 1991) • Active investing is zero-sum game • Because 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

12. Passive vs. Active Management • Passive investor – Bob – hold every security in the market • If Security B represents 5% of the market, John will hold 5% of his portfolio in B • Active 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

13. Distribution of Market Returns • 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

14. After cost distribution of mutual fund returns Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 6

15. Useful terminology • Alpha - portfolio’s risk-adjusted excess return vs. it’s benchmark • Beta - measure of magnitude of a portfolio’s past share price fluctuations in relation to the market’s volatility

16. Indexing’s advantage • Lower costs • More 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 returns • Research 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

17. Returns vs. cost – inversely related Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 8

18. Active what? Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 10

19. Individual investors • If 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?

20. We’re not that old to think about retirement Tax & Retirement concerns

21. Traditional vs. Retirement Accounts • To help us in retirement, we have the option of investing in special tax-deferred accounts • Grows absolutely tax free • Don’t owe Uncle Sam a dime! • Depending on the tax bracket, we’re talking about serious money here

22. Roth vs. Traditional IRAs • Traditional – 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

23. Roth > Traditional • You will likely be in a higher tax bracket when you retire than right now as a student • More flexible – can withdraw early at anytime without penalty (NOT recommended – can’t put them back in later!) • No mandatory age-based distribution schedule – manage your own income stream after retirement • You contribute more with Roth - $4,000 in a Roth is worth more than pre-tax in a traditional IRA

24. 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

25. 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 lessthan if she chose the Roth, down even more if there was state tax

26. Roth IRA Contribution Limits • Starting 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

27. Roth IRA drawbacks • Need 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

28. The Experts The pros weigh in.

29. What does Swenson say? He says it is fruitless for individual investors to pick stocks. “There is no way that an individual can go out there and compete with all these highly qualified and compensated professionals,” Mr. Swensen said. 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 Don’t be distracted by market forecasts, he said. “You have to diversify against the collective ignorance,” he said. “I think nobody is in a position to react to these big macro-issues. Where is the dollar going to be or what is G.D.P. growth going to be in China? For every smart person on one side of the question, there is another smart person on the other side.” (Swenson quoted in the NY Times Feb 17, 2008) Regarding market declines like the current one we’re experiencing, Swenson recommends just ignore it. “Let yourself off the hook,” he said. “If you pursue the sensible long-term policy, look at it over a 5- to 10-year period. Don’t look at five months.”

30. What does Buffett say? In April 2008, at a talk with 150 Wharton business students… Buffet was asked: What advice would you give to someone who is not a professional investor? Where should they put their money? “Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time. ” Warren Buffett, the greatest investor that ever lived, supports indexing. “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 When asked about the health of the US economy… But you're still bullish about the U.S. for the long term? “The American economy is going to do fine. But it won't do fine every year and every week and every month. I mean, if you don't believe that, forget about buying stocks anyway. But it stands to reason. I mean, we get more productive every year, you know. It's a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market.” “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

31. Investing Principles Time-tested investment principles to live by.

32. Some Investing Principles • Wall 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 • Don’t put all your eggs in one basket. • There is no such thing as a free lunch. • Save.

33. 1. Don’t Put all your Eggs in One Basket • Diversify into different asset classes • Top 10 funds in the hottest 2 sectors does not mean diversification • Instead of trying to time the hot sectors, own ALL of them

34. 2. There’s no such thing as a free lunch • Wall 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?"

35. 3. Save • Develop a long-term financial plan • Ignore 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

36. Portfolio Considerations Things to consider when building your first portfolio.

37. Asset Allocation • Once 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

38. Stocks & 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)

40. How much International 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

41. Portfolio Construction • Basically, you want to invest as much as possible in tax-deferred accounts • Put the most tax-inefficient investment products in tax-deferred accounts • Use only tax-efficient funds in taxable accounts • Open a Roth IRA now!

42. Mock Portfolio #1 • For 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

43. Portfolio Considerations • Total 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%)

44. Index funds or ETFs • You 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!)

45. Mock Portfolio #2 • 50% Total Stock Market • VTI, IWV, VTSMX • 30% Total International • EFA, EEM, VEU, VGTSX • 10% Bonds • VBMFX, BND • 5% Small-cap value • IJS, VBR, VISVX • 5% REIT • RWR, VGSIX, VNQ • Compare expense ratios on prospective funds

47. Some last minute Administrative points

48. Extra reading • Research papers on this subject if you’re interested: • Sharpe – The Arithmetic of Active Management • Won the 1990 Nobel Prize in Economics for developing CAPM • Thorley – The Inefficient Market Argument for Passive Investing

49. Feedback • Please take the time to fill out this anonymous course feedback form: • http://spreadsheets.google.com/viewform?key=pt5fXqd0_YmOQNjbOdB-CKg&email=true • I appreciate your comments!

50. “Office Hours” • Portfolio help • Analyzing your current holdings • E-mail me if you have any questions, I’ll hold “office hours” at 4:00pm at Café Strada next Wednesday (4/29)