Search Results for: Buying Stocks

To get the full return of any asset class, you’ll have to own it through the good times and the bad times. The good times are easy, but getting through the bad times requires deeper understanding and faith. You’ll usually hear this about holding stocks through their inevitable drops and crashes. But recently, many bond funds have dropped in value instead. Here’s a somewhat-reassuring chart from A Wealth of Common Sense comparing historical drawdowns between the S&P 500 stock index and 5-Year US Treasury bonds:

Even so, having an investment that is supposed to be “safe” wobble 5% can still be worrisome. If Bank of America or Chase Bank announced tomorrow that their customers with balances above FDIC limits would lose even 1% of their excess deposits, there would be a huge crisis due to the perceived level of safety. A recent post by Longboard Funds makes an interesting claim: “…investors destroy more of their bond returns than their stock returns.”

This statement reminded of my surprise when reading this Bogleheads forum post on 11/14/16:

Bonds have been dropping every day [recently…]
Why? I thought they were a stable fixed investment.

S/he wasn’t alone, and I received a couple of similar e-mails, but I was struck that this person had been a member of the forum for over 2 years, made over 600 posts, and had previously detailed their asset allocation very specifically: “Brokerage account 65/35 | VG total Market 35% | VG total Intl 12% | VG small cap value 12% | VG Reit index 6% | VG Total Bond 35% | TSP Account 75/25 | C Fund 45%, S 15%, I 15%, G 25% | EE Bonds = Emergency Fund” Why did they buy all these things? No doubt from reading a lot of well-meaning advice from well-meaning people.

Bonds can certainly go down. There are also many different types of bonds. Longboard Funds put the two major risks of bonds into a nice graphic:

This won’t be a bonds primer, but instead I offer up how I try to treat bonds as part of my investment portfolio:

• I own bonds as a ballast and diversification element in my portfolio. (I also own stocks for inflation-beating growth.) I want relatively low volatility, but there will still be some based on credit and duration risk. I will take a little bit of each type of risk, but not too much.
• I also own bonds for modest income. I will be satisfied earning only modest interest rates that will roughly match inflation over the long run, and be happy if I earn 1% or 2% more than inflation.
• In order to take on a small amount of credit risk, I will stick to US Treasury bonds, investment-grade corporate bonds, and investment-grade municipal bonds.
• In order to take on a small amount of interest rate (duration) risk, I will stick to bond mutual funds with a relatively short duration (less than 5 years). The term “intermediate” could mean anything from 2 years to 10 years, so I’ll have to be careful. As a result, I will be less-exposed to short-term losses if interest rates rise quickly.
• In order to reduce the risk of any single bond default, I will own a large number of bonds inside a mutual fund or ETF. An exception would be individual US Treasury bonds as they all share the same, highest credit quality available.

Someone else may want to pursue higher bond returns and be willing to take on more risk. You could buy bonds from countries with shakier credit ratings. You could buy bonds from riskier companies. You could buy bonds with longer duration/maturities.

If you look again at that top chart, you can see several drawdowns of around 5% for a 5-Year Treasury. But what about a 20-Year Treasury, or 5-Year Junk Bonds, or international bonds from Argentina or Venezuela? It’s possible for some bond funds to drop 10% or more. If you are buying bonds because you think they are safe, stick to the safer bonds and realize that even they might still drop in price for a while.

Howard Marks released another Oaktree memo earlier this month that somewhat coincides with this weekend’s Super Bowl. Inside, he revisited the New York Post NFL Bettor’s Guide, a panel of “experts” offering their opinion of winning picks for each NFL game during the season. The picks are relative to the point spread offered by the bookmakers. The experts further specify up to three “best bets” each week.

Here were the results after the 2015 NFL Season (from last year’s memo):

Here were the overall results after the 2016 NFL Season:

• The best picker was right 55.1% of the time.
• The worst picker was right 48.8% of the time.
• On average the pickers were right 51.6% of the time.

In terms of the “best bets” only:

• The best picker was right 62.7% of the time.
• The worst picker was right 43.1% of the time.
• On average the pickers were right 54.0% of the time.

Here’s my take on the observations in the memo:

All results cluster closely around 50/50. A blindfolded squirrel (or me flipping a coin) could easily blend in with this panel of “experts”. Some do a bit better than 50/50 (but not much better), while others do a bit worse (but not much worse). This is exactly what the distribution of a high number of coin tosses looks like. It’s very hard to consistently beat the point spread created by the “market” consisting of other bettors.

Don’t forget the vigorish. When you place a bet with a sports book, they charge a fee (“the vig”) for their services. For example, you may have to bet $110 to win $100. That translates to a roughly 5% commission on each bet. Even if you were right on average 54% of the time, you would still lose money in the long run after fees.

These are results from people who are paid to observe, analyze, and write about football games. Yet their performance could be mostly explained by luck, and even any slight outperformance on average is more than negated by fees.

In terms of investing, there are also many “experts” willing to offer their opinion on winning stock picks or other financial forecasts. Most will be average, or perhaps even slightly above average. However, history (and common sense math) shows that their performance won’t be good enough to offset the higher fees that they charge. In addition, there is no surefire way to find these above-average pickers ahead of time (using past performance doesn’t work). Due the presence of such fees, you can guarantee yourself “above average” net results by simply buying low-cost index funds.

I’m not one of those people that completely dismiss the possibility of skill in investing, but you if do want to go that route you should be realistic. If you’re picking your own stocks, keep an honest tab on your performance. If a mutual fund is charging 1.5% annually today to actively manage US stocks, it is rather unlikely that it will outperform a low-cost US stock index fund in the long term. On the other hand, an actively managed mutual fund that charges 0.15% annually and has various other positive factors has a more reasonable chance of slight outperformance. However, at the same time you must also accept the possibility of slight underperformance.

As we close in on the end of the year, it is a good time to take stock of your investment portfolio. If you haven’t already, you should consider rebalancing your portfolio back towards your target asset allocation. Overall, this means selling your recent winners and buying more of your recent losers.

Now, you may think that rebalancing will improve your returns because you are “selling high” and “buying low”. However, the full picture is a bit more nuanced than that. If you think about it, the asset classes with the highest returns should eventually take over the portfolio if you never rebalance. If you started in 1965 with 50% stocks and 50% bonds and did nothing to 50 years, your portfolio in 2015 would have been overwhelmingly stocks. If you kept selling stocks and buying bonds, you would have probably lowered your returns in the long run. So why rebalance?

In his post How Portfolio Rebalancing Usually Reduces Long-Term Returns (But Is Good Risk Management Anyway), Michael Kitces provide a handy visual to summarize the effect of rebalancing into two scenarios:

1. When rebalancing between asset classes with similar returns, the likely effect is to help increase your overall returns while not affecting your risk. An example is rebalancing between US and International stocks.
2. When rebalancing between asset classes with different returns, the likely effect is to help lower your overall risk (improving your risk management in the chart) while decreasing your overall return. An example is rebalancing between stocks and bonds.

In the end, Kitces reminds us while your overall returns probably won’t be enhanced, the net effect of rebalancing is better risk management. I think of it similarly as preventing my portfolio from getting “out of control”. This is why people create “rebalancing bands” that let their portfolios wander a bit but not too much. For example, a 20% target allocation can vary from 15% to 25% before being rebalanced back towards the target number.

Vanguard has a new research paper about global asset allocation. One of their findings was that market-cap-weighted indexed portfolios provided higher returns and lower volatility than the average actively managed fund. Thus, they suggest that a good starting point for all investors is a portfolio that is weighted according to the world’s relative market values.

However, in every country that they examined, investors on average had a home-country bias, tending to own more equity from the country they live in than the market-cap weighting would suggest. The chart below is rather striking. Found via Reformed Broker and Abnormal Returns.

Americans on average hold roughly 80% in US stocks, while the US market makes up 50% of the global market. However, the average Canadian resident holds roughly 60% in Canadian stocks while only making up 3% of the global market. Australian residents hold roughly 66% in Australian stocks while only making up 2% of the global market. I find this very interesting.

This is where I should state proudly that my stock holdings are split 50% US and 50% International, with equal amounts of the Vanguard Total US ETF (VTI) and Vanguard Total International ETF (VXUS) or their mutual fund equivalents. However, I admit that I do worry about the political and economic environments of other countries, especially given current events. On the other hand, I worry that I am being influenced by recent past performance. I usually end up telling myself that I am buying the haystack and letting the markets work themselves out over the long run.

The Vanguard paper also offers a guide to weighing various factors in deciding the amount of your home bias. Here’s a summary chart:

I lent out my first $25 to a stranger on Prosper nearly 8 years ago, in October 2007. Since then, the peer-to-peer (P2P) lending environment has undergone a variety of changes. I’ve made hundreds of P2P loans both hand-picked and algorithm-driven, sold them on the secondary market, and experienced the effect of defaults on my returns.

I’ve written several posts along the way, but here is my condensed (but still detailed) overview. Many of the other Prosper reviews tend to focus on the positives. While Prosper certainly has potential, I’d rather go deeper into the possible risks to an investor’s hard-earned money.

The attraction: Be the bank. Earn high interest rates. We’ve all seen the big banks charge mountains of interest, while us regular folks pay it. The average interest rate on credit card loans remains around 15% APR. The basic model for P2P loans is that anyone can become that bank and invest in loans to other individuals. Prosper will take a little cut for helping out, but the bulk of the interest (and risk) goes to the investor.

The reality: Higher net returns than other alternatives, but the risks hide in the details.

Detail #1: Significant loan defaults occur over time. The good news now that P2P loans have been around for a while is that you have more historical performance numbers to consider. Prosper lets you see this historical data in great detail, but you have to look carefully. Here’s a snapshot of what you’d see now at Prosper.com/Invest, labeled “Seasoned Returns*”.

Here’s what that asterisk means:

*Seasoned Return calculations represent historical performance data for the Borrower Payment Dependent Notes (“Notes”) issued and sold by Prosper since July 15, 2009. To be included in the calculations, Notes must be associated with a borrower loan originated more than 10 months ago; this calculation uses loans originated through May 31, 2012. Our research shows that Prosper Note returns historically have shown increased stability after they’ve reached ten months of age. For that reason, we provide “Seasoned Returns”, defined as the Return for Notes aged 10 months or more.

The initial interest rate on your notes is only a theoretical maximum return. For example, for the last quarter of 2015, the average interest rate was 11.06% for 36-months 15.47% for 60-month loans. Every time a borrower defaults – and trust me, if you buy any meaningful amount of notes, some will default on you – your return will go down. With loans as little as 10 months old, their quoted “increased” stability is not the same as stability.

Here’s a chart from competitor LendingClub showing how net annualized return has decreased with loan age (for different vintages of past loans). Note that the net return numbers still keep going down after 10 months.

If anything, I would prefer to use this alternative table provided by Prosper. These estimated net numbers are more realistic. The table also includes a daily snapshot of their current inventory, which may give you an idea of relative availability by rating. Note that there are much fewer of the highest-risk, highest-expected return loans available.

Finally, don’t forget that not everyone gets the average. You can’t buy a “Prosper index fund”. You may be above average, but be prepared for below-average returns as well.

Detail #2: Liquidity concerns. When you buy traditional mutual fund that holds investment-grade bonds, with just a few clicks, you can sell that investment on any given trading day. You will get a fair market price, and you will find a buyer for all of your shares.

If you invest in a Prosper note and you need to cash out before maturity, you will have to sell on the secondary market. Now, if you have pristine loans with a perfect payment history, today you’ll probably be able to sell your notes at near or even slightly above face value. But here are the possible haircuts:

First, you will have to pay a transaction fee of 1% of face value on all sales. Second, if you have loans that have ever been late or has a borrower whose credit score has decreased since loan origination (they track that), you will have a harder time finding a buyer and the price will probably be lower than face value. Finally, for Prosper if your loan is currently late, you can’t sell it on the secondary market for any price. You can’t even offload it for a penny.

In my experience, I liquidated ~85% of my loans at about a 0% net haircut, ~10% were sold at a slight loss due to their imperfect history, and ~5% could not be sold at all. While this is certainly better than having no liquidity at all (like a lot of real-estate crowdfunded debt), it also takes a few hours of work at least to maximize your selling prices on 100 or 200 loans.

All of these haircuts taken together can take a significant hit against your total returns. Also, just because you have buyers today doesn’t mean there will be buyers tomorrow. Therefore, I would not invest if you don’t expect to hold the loan until maturity. Some people try to arbitrage things by buying notes and selling them quickly on the secondary market to residents of states that can only buy notes on the secondary market.

Detail #3. Diversification is critical. A defaulted loan wipes out both principal and interest, resulting in a big hit on your overall return. Therefore, your best bet is to never put any more than the $25 minimum into any one note. Remember this statistic: For Notes purchased since July 2009, every Prosper investor with 100 or more Notes has experienced positive returns. In other words, no investor has lost money overall if they held at least 100 notes! 100 times $25 = $2,500 which I think is the minimum you should invest with.

Detail #4. Taxes. P2P notes are a somewhat different animal, and at year-end you’ll receive some tax forms that will be unfamiliar to most people. These may include:

• 1099-OID
• 1099-B (Recoveries for Charge-offs)
• 1099-B (Folio secondary market)
• 1099-MISC

If you file your income taxes yourself, it is not impossible to figure out but it will take some extra research and effort. Here is my Prosper tax guide that offers some guidance. If you pay a tax professional, they may charge extra for the added complication.

For the most part, the interest you receive will be taxed as ordinary income, the same rate as interest from bank savings accounts. This can be quite high depending on your income, so you may want to consider holding your Prosper notes inside a tax-sheltered IRA. Looking back, I wish I put my Prosper notes inside an IRA.

Detail #5. Automatic investing. The days of hand-picking loans are pretty much over. I recommend using the Quick Invest feature that Prosper offers in order to automatically filter through and buy the notes that fit your criteria. Loan supply is often limited, and this way you can actually get those loans before someone else buys them.

You can let Prosper pick the loans for you, or you can spend your time looking for “better” filters. There are some free tools out there that help sift through the past performance data. There are even paid services out there that do this for you, but I am uncertain how the cost/benefit would shake out.

Detail #6. Past performance vs. future possibilities. Although past returns are great, another economic recession may have a severe impact on your future loan returns. In the end, these are unsecured loans like credit card debt. If people lose their jobs, they will stop paying. Just because nobody has lost money in the past with 100+ loans, that doesn’t guarantee that you won’t lose money in the future. Unlikely does not mean impossible.

Traditionally, high-quality bonds are a diversifier to stocks. But Prosper notes are more like low-quality bonds. If the economy tanks, defaults will rise and your returns will drop. But if the economy tanks, your stocks will drop too. Are you ready for both to suffer significant drops during times of financial stress?

Detail #7. What if Prosper goes bankrupt? As a company, Prosper Marketplace Inc. (PMI) has historically had a hard time actually making a steady profit themselves. In 2013, Prosper started structuring their notes so that they are held in a new legal entity called Prosper Funding LLC (PFL). This remote entity is designed to stand alone and be protected from any creditor claims in the event that Prosper Marketplace, Inc. goes bankrupt. PFL can keep on running and servicing loans. This is a good move in my opinion, but it is still unknown how well this legal strategy will work, or if future lawsuits can put the assets of PFL at risk.

In other words, don’t put all your eggs in one basket. Due to #6 and #7, Prosper notes should only be a portion of your fixed income assets.

Summary. P2P loans are becoming a legitimate asset class, gathering billions of dollars from Wall Street and other institutional investors. Interest rates remain low, and thus the high yields and competitive past returns from these Prosper notes are still very attractive. Let’s face it, even a tempered expectation of 8% net annual return is hard to ignore! But before you make the jump, make sure you fully understand the risks and how to best mitigate them.

• Understand that your final returns will be significantly less than your starting yield. Look at historical numbers for guidance.
• Don’t invest money you will need before the loan ends (3-5 years).
• Diversify across as many loans a possible (100+ notes).
• P2P notes should only be a portion of your fixed income assets.
• Expect to spend extra time to acquire notes and prepare taxes.
• Consider holding notes inside a tax-sheltered IRA.

I hope that this information helps you decide whether investing in Prosper loans is right for you.

As 2015 winds down, here is a snapshot of the asset class forecasts provided by GMO and the most recent market commentary by co-founder Jeremy Grantham. You can access both of these at GMO.com, although some items require free e-mail registration.

Here is a snapshot of their 7-year expected future returns by asset class, inflation-adjusted, published in mid-December 2015 and using data as of November 30, 2015.

The chart represents real return forecasts for several asset classes and not for any GMO fund or strategy. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Forward-looking statements speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in forward-looking statements. U.S. inflation is assumed to mean revert to long-term inflation of 2.2% over 15 years.

I like to keep track of these forecasts along with those provided by:

• Research Affiliates Expected Returns by Asset Class Tool
• Portfolio Solutions® 30-Year Market Forecast for 2015
• Reasonable Expectations for Financial Market Returns – John C. Bogle and Michael W. Nolan, Jr.

Here are some reasons why I like keeping track of these types of forecasts:

• The projections are based on fundamental, historical, and valuation-based models. This is not to say they can’t be wrong, but the strategy is at least unemotional and provides a reasonable range of expectations.
• They usually provide support for rebalancing and buying more of beaten-down and unpopular asset classes. Currently, Emerging Markets stocks would fit that description.
• They usually temper the mass enthusiasm for putting all your money in hot and popular asset classes. Currently, US stocks would fit that description.