Investor Education | The Financial Coaching Group

16 Meaningless Market Phrases – #1

June 22, 2011 By Michael Stokes Leave a Comment

“The easy money has been made”

When to use it: When you are asked whether investors should buy a market or stock that has already gone up a lot.

Why it’s smart-sounding: It implies wise, prudent caution. It implies that you bought or recommended the stock a long time ago, before the easy money was made (and are therefore smart). It suggests that there might be further upside but that there might also be future downside, because the stock is “due for a correction” (another smart-sounding meaningless phrase that you can use all the time). It does not commit you to any specific recommendation or prediction. It protects you from all possible outcomes: If the stock drops, you can say “as I said…” If the stock goes up, you can say “as I said…”

Why it’s meaningless: It’s a statement of the obvious. It’s a description of what has happened, not what will happen. It requires no special insights or powers of analysis. It tells you nothing that you don’t already know. Also, it’s not true: The money that has been made was likely in no way “easy.” Buying stocks that are rising steadily is a lot “easier” than buying stocks that the market has abandoned for dead (because everyone thinks you’re stupid to buy stocks that no one else wants to buy.)

Filed Under: Financial Lies & Truths, Investor Education Tagged With: Financial Planning, Investing, Investments, Predictons, Stock Markets, Stocks

16 Meaningless Market Phrases That Will Make You Sound Smart On TV

June 21, 2011 By Michael Stokes Leave a Comment

If you watch financial television all day, like we do, you’ll quickly notice something. A handful of guests have the confidence and guts to speak actual English and say what they mean. These guests are invaluable: Their opinions are backed up by logic and conviction, they state them clearly, and they make specific statements and recommendations that normal viewers can understand. Even when these guests are wrong, their clarity helps you refine your own opinions–even if you disagree.

Of course, these guests also expose themselves to all sorts of potential ridicule–if the predictions or statements they make turn out to be wrong.

And that’s why the vast majority of guests speak a language unique to financial television.

This language consists of market phrases that you hear all the time that sound vaguely intelligent but actually don’t mean anything.

The phrases don’t sound like they don’t mean anything, of course: On the contrary, they appear to mean a lot. In fact, to the inexperienced listener, they make the speaker sound as wise as Warren Buffett (who, to his credit, never speaks this way). The phrases are often inscrutable to lay viewers, leaving them with the impression that, if they don’t understand what the guest has just said, it’s because they’re just too stupid to understand.

Most of these phrases also have another key benefit, which is especially useful in the investment business: They never commit the speaker to any specific recommendation or prediction.

In other words, no matter what happens after the guest removes his or her makeup and returns to their office, they can never be “wrong”–because they didn’t actually say anything!

Over the next few weeks, I am going to outline these phrases, when the “smart” experts use them, why it’s smart sounding and why it’s meaningless to you.

Filed Under: Financial Lies & Truths, Investor Education Tagged With: Investing, Investments, Money, Predictons, Stock Markets, Stocks

The 3-Factor Model – Impact On Investing

June 21, 2011 By Michael Stokes Leave a Comment

Fama and French’s research revolutionized how people invest. Their documentation of the size and value risk factors has advanced the framework for understanding performance of stocks and portfolios, while the three-factor model offers a powerful tool for investment analysis, planning, and allocation.

The single-factor model proposes that a portfolio’s expected return is a function of its relative sensitivity to the market premium. For example, a portfolio with a beta of 0.80 is expected to have a return that is 80% of the market’s historical average premium over T-bills. Any return above or below this expectation is attributed to a manager’s alpha. The single-factor model is estimated to explain about 70% in the return differences between portfolios.

The three-factor model is a much-improved extension of the single-factor model. It more clearly describes the sources of return and provides a way for investors to systematically capture these returns through portfolio structure. In addition to the market factor, the model incorporates a portfolio’s sensitivity to size and price factors. (The size factor is the return difference between small cap or large cap stocks; the value factor is the return differences between high BtM stocks and low BtM stocks.)

Once a portfolio is adjusted for its relative exposure to these factors, any return above or below its return is attributable to manager skill. According to Dimensional’s own research, the multi-factor model explains about 96% of the variation in returns between portfolios.

To learn more or get started, click HERE

Filed Under: Free Market Theory, Investor Education Tagged With: Investing, Michael Stokes, Money, Stock Markets, Stocks, The Financial Coaching Group

The 3-Factor Model – Should You Invest?

June 14, 2011 By Michael Stokes Leave a Comment

Eugene Fama and Kenneth French were the latest in a series of academics that attempted to find a more robust model to explain the differences in the returns of stocks and portfolios. They attempted to identify risk factors that explain the common variation in returns—that is, the differences between individual stock returns during a specific time period and the variation of stock returns through time. A factor that is independent and non-diversifiable (systematic) is also considered a dimension or source of risk.

In their search for risk factors, they ran cross-sectional regressions on stock returns for the 1963-1990 period and tested the relationship of several variables on returns. These variables included earnings/price, leverage, cash flow, book/market, and size. They found that size and book-to-market (BtM) to be the strongest determinants of stock performance and that these two factors, combined with Sharpe’s market beta, explain almost all of the average differences among stock returns.

Overview:

Market: Stocks have higher expected returns than Treasury bills.
Size: Small company stocks have higher expected returns than large company stocks.
Price: Lower-priced “value” stocks, as defined by a higher book-to-market (BtM) ratio, offer higher expected returns than low BtM (higher priced) stocks, commonly known as “growth” stocks.

I will explain more in my next post…

Filed Under: Free Market Theory, Investor Education Tagged With: Investing, Michael Stokes, Money, Portfolio Risk, Prudent Investing, The Financial Coaching Group

Why Hold Bonds?

May 30, 2011 By Michael Stokes Leave a Comment

Investors hold bonds for one of two reasons: To generate income or to reduce portfolio volatility. The following explores the rationale for each approach and considers investment implications.

Bonds to Generate Income

The income approach is typically implemented by retirees, institutions, and others who need a predictable stream of income. They may regard fixed income and equities as separate and distinct elements in their portfolio. If asset growth is not their primary concern, they can accept a lower expected return relative to stocks. To improve their yield, they may hold bonds with slightly longer maturities and slightly lower credit quality—and diversify to reduce the risk of individual issues.

As mentioned before, assuming higher doses of term risk and default risk in pursuit of higher returns has a limited payoff. Moreover, active fixed income management does not appear to pay for itself in an efficient bond market. So, what strategy should investors implement? Investors may be able to increase their risk-adjusted returns with an alternative approach developed by Eugene Fama. His variable maturity strategy shifts the maturities of the portfolio as changes in the yield curve create the possibility for lower risk, higher expected return outcomes.

Since the fixed income markets are efficient, Fama reasoned, changes in interest rates (bond yields) are largely unpredictable. Consequently, today’s yield curve is a good estimate of future yield curves.

In recognizing the bond market as being highly efficient, the variable maturity approach does not anticipate changes in the yield curve, but rather, seeks to maximize the risk-adjusted returns present in the current curve.

Bonds to Mitigate Portfolio Risk

Investors who want to maximize long-term wealth can also use fixed income to reduce overall volatility in their portfolios. In general, a total portfolio approach looks to equities to generate higher expected returns, and uses fixed income to dampen volatility.

Since stocks offer higher expected returns than bonds, an investor finds the optimal stock allocation in a diversified market portfolio, then controls risk by adding more or less fixed income. This approach does not force an investor to compromise an optimal stock mix in search of lower risk. In essence, separation theorem encourages investors to make the best use of risk by constructing a diversified stock portfolio, then holding a diversified fixed income allocation to temper the higher risk of equities.

See how bonds can be a great fit to your portfolio. Click HERE to get started investing with us.

Filed Under: Investor Education Tagged With: Bonds, Financial Planning, Fixed Income, Investing, Michael Stokes, Money, Stock Markets, The Financial Coaching Group

Should You Invest In Equites Around The World

May 23, 2011 By Michael Stokes Leave a Comment

If the market, small cap, and value premiums reflect systematic risks in the US stock market, research should provide evidence of these risk dimensions in other markets as well. This is, in fact, the case. The international findings are consistent with Fama’s and French’s size and value research. Similar size and value effects are present in most international developed markets, as well as emerging markets. This suggests that equity markets around the world operate efficiently, and offer higher expected rewards for bearing higher systematic risk.

In general, investors should hold an international component in their portfolio only if the addition produces higher expected returns or broader diversification. Empirical evidence shows that the international stock market has historically delivered average returns that are similar to the US market and highly correlated with it. This is due to the similarities and dominance of large cap growth stocks in the respective markets. As a result, investing in a market-like international portfolio may be useful only as a diversification tool.

Small cap and value stocks around the world are a different matter, however. These risk factors are not highly correlated with the US market and do offer an expected return premium for taking higher risk. Consequently, investors can increase expected returns and decrease volatility by holding an international equity component that over-weights small cap and value stocks. Adding international size and value asset classes also improves diversification in a portfolio.

However, moving into international equities poses challenges due to greater market frictions. For one, international stocks are more costly to trade and their dividends are subject to foreign taxation. Also, in some countries, the universe of stocks is much smaller than in the US, which may pose a diversification challenge. There are also market, transparency, and legal issues to manage by country, especially in the emerging markets.

The answer is clear: You should invest in equities around the world for many reasons.

Click HERE to get started investing with us.

Filed Under: Investor Education Tagged With: Diversification, Financial Planning, Global Diversification, Investing, Michael Stokes, Money, Stock Markets, The Financial Coaching Group

How To Invest Efficiently

May 9, 2011 By Michael Stokes

Confidence in the power and efficiency of markets has important implications for investors. If current market prices offer the best estimate of real value, investors should regard stock mispricing as a rare and temporary condition. Equally essential, they should avoid spending time and effort trying to identify and exploit mispricing that might occur as prices seek equilibrium.

If professionals with virtually unlimited resources cannot apply research and analysis to pick winning stocks, it is even less likely that individuals can outperform the market. The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform markets, but not without accepting increased risk.

Investors who believe that capital markets are efficient choose a different path to building wealth. Rather than trying to outguess the capital markets, they let the markets work for them by capturing the sources of risk and return in their portfolios through a structured, passive approach.

Click HERE to get started investing with us.

Filed Under: Investor Education, Retirement Analyzer Tagged With: Financial Planning, Investing, Michael Stokes, Money, Prudent Investing, Stock Markets, The Financial Coaching Group

Testing Stock Market Efficiency

May 2, 2011 By Michael Stokes

There is perhaps no better test of market efficiency than the investment industry itself. In fact, active managers put market efficiency to the test every day as they research companies in quest for mispricing. If market prices do not reflect fair value, the more skillful managers should be able to add value by finding mispriced stocks and outsmarting other market participants consistently.

Today, the investment industry takes for granted the calculation of rates of return and the availability of other data to evaluate investment performance of stocks and professional managers. But before the mid 1960s, there was neither a generally accepted way to calculate a total return nor a way to compare the returns of different funds. This all changed with the advent of computers and the collection of returns data for stocks and bonds.

Researchers began studying professional money manager performance, and for the first time, they could compare the returns of active managers to the overall market and assess whether these managers added value (after fees) through their active efforts to analyze stocks and forecast the direction of individual securities and markets. Noteworthy researchers on mutual fund returns include Sharpe (1966), Jensen (1967), Malkiel (1995), and Carhart (1997). These are only a few of many academics who asked whether professional money managers could apply their research and skills to consistently outperform the broad market. Survey papers that describe this work include Davis (2001) and Malkiel (2003).

The body of evidence has casted doubt on the value of active management. In general, the research shows that the number of successful long-term managers is no greater than what would be expected by chance. Moreover, despite their efforts to identify “mistakes” among stock prices, few professional managers demonstrate an ability to exploit mispricing. A major reason for their underperformance is the higher management fees and transaction costs required to implement active management.

Despite this evidence, however, active management strategies still dominate the investment industry, and most investors believe that smart professionals can use research to identify pricing mistakes and predict future market movements. But their efforts typically incur higher fees and trading costs, and result in higher risk exposure and lower returns for investors.

To get started investing with us, click HERE.

Filed Under: Investor Education Tagged With: Financial Planning, Investments, Market Timing, Michael Stokes, Money, Prudent Investing, Stock Markets, The Financial Coaching Group

How Bond Markets Work – Part 2

April 26, 2011 By Michael Stokes

The fixed rate of interest a borrower must pay is influenced by current market rates, the entity’s creditworthiness, and length of term. Over time, these factors will change, which affects the bond’s market price. The price reflects the present value of all expected future interest payments and return of principal, discounted at the bond’s rate of return, or redemption yield. This yield represents the current market interest rate offered on new bonds with similar traits. The bond’s current yield is the interest rate adjusted for the current price of the bond.

Many investors overlook the fact that stock and bond markets follow a similar process when setting prices and returns (yields) in the secondary market. A bond’s coupon rate is essentially the company’s cost of capital. Although an issuer’s credit quality, maturity, coupon rate, and other factors may influence trading, current interest rates have the most influence on price changes in the market. When the interest rate rises, a bond’s price falls to make the yield equivalent to newly issued bonds that offer the higher coupon rate. This inverse relationship between price and yield follows the same dynamic as stocks.

To get started with us, click HERE.

Filed Under: Investor Education Tagged With: Bonds, Financial Planning, Investing, Michael Stokes, Money, Stock Markets, The Financial Coaching Group

How Bond Markets Work

April 25, 2011 By Michael Stokes

A bond is a debt security issued by a company, public authority, supranational institution, or other entity as a promise to pay interest to the lender (bondholder) for a given period of time and reimburse the original principal at the term’s end. Bonds have financed government and private enterprise for centuries and are traditionally regarded as less risky than equity shares since bondholders in most countries have a legal claim to an issuer’s assets. Bond volatility is generally lower than stock volatility, but bonds also have offered lower historical returns because the debt holder is not an equity owner and typically does not participate in company profits or value appreciation.

New bonds are issued through an underwriting process in which securities firms or banks form a syndicate which buys all the bond debt from the borrower and resells the bonds to institutional and individual investors. Government bonds are typically issued through an auction. The secondary bond market comprises mostly decentralized venues where secondary trading occurs between dealers, such as investment banks and other institutions, in the over-the-counter markets. These dealers provide liquidity to the markets and take trading risk. Some corporate bonds are listed on exchanges, with the NYSE being the largest centralized bond market.