Improving Your Investment Odds

A remarkable study recently revealed that a clear 90% of the population in North America reads at a grade seven level. That's because we learn to read by the time we have reached grade seven and never improve our reading ability from that point on. Shocking, isn't it?

Well it is not only shocking, it's a shame. But what is even worse, is that this lack of personal development goes well beyond reading. Most people do whatever they do in much the same manner. There are very few people who master anything - be they managers, lawyers, accountants, and yes, individual investors!

There really is no competition when it comes to improving your odds as an investor. To be sure, there are many out there making a noise, but only a few souls are making any serious effort to actually study the craft of investing or perfect it. After all, how many Warren Buffett or Peter Lynch types can you name?

One way to improve your investment performance is to begin to seriously study what you are doing for a short time every day, knowing that you can always perform better. Work toward a specific result well beyond your present level of performance.

Just one hour of concentrated study each day adds up to nine forty-hour weeks in one short year. Think of how much more you would know about investing in five, ten, or twenty years - if you adopted this plan!

When you begin to study investing, you will learn this great secret of achievement: If you want more, you must know more; and to know more, you must study.

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Don't Buy Bond Funds!

Yes, that is a broad generalizaton to be sure. Obviously, there are certain circumstances in which a bond fund will do. But most investors who buy bond funds could do better elsewhere. Even those looking for income can find alternatives.

Bonds hold less return potential than stocks - a good two percentage points less on average, according to Sanford C. Bernstein & Co., a Wall Street research house. But when you place a bond in a bond fund, you run into some additional problems.

Bond funds carry high expenses. The average municipal bond fund sports expenses of 1.01 percent; the average corporate bond fund 0.91 percent; the average government bond fund 1.08 percent; the average international bond fund 1.40 percent; and the average emerging market bond fund 1.78 percent, according to Morningstar Mutual Funds.

A study by New York bond dealers Gabriele, Hueglin & Cashman comparing yields on individual bonds, unit investment trusts, and bond mutual funds found that bond funds consistently underperformed the other two, sometimes by more than 2 percent a year. The funds' fees depressed their yields year after year, making them less attractive the longer they are held, according to the study.

Bond funds are inconsistent performers, making it impossible to select one winner from a bad batch, according to a study by Lewis J. Altfest, a financial planner and professor at Pace University in New York City.

"There are no Peter Lynches in the bond market," Altfest says. "There are no bond funds that consistently outperform the average. One bond fund manager is just as good as another, and no one could outperform the indexes."

Few bond funds offer unique strategies. The thing that gives a mutual fund its franchaise - the quality of its management - plays only a small role in bond funds. The best bond fund manager might turn in 11 percent, and the worst 9 percent. In contrast, stock fund performance might range from +95 percent to -40 percent.

Bond funds don't allow you to target your own goals or employ your own strategies. If you buy a bond fund because you think bonds are a good value now compared with stocks, or because you think interest rates will fall and bond prices will rise, the bond fund manager can defeat you by moving into shorter-term bonds.

So what should you do? An investor looking for income might try some funds with a mix of high-dividend stocks, preferrerd stocks, utilities, and perhaps REITs. Two possible choices are the Vanguard STAR and Vanguard Wellesley Income funds.

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A Simple Lesson In Economics

Suppose that every day ten men go out for dinner and the bill for all ten comes to $100. If they pay their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.

The fifth would pay $1.

The sixth would pay $3.

The seventh would pay $7.

The eighth would pay $12.

The ninth would pay $18.

The tenth man (the richest) would pay $59.


So that's what they decide to do.


One day the restaurant owner says, "since you are all such good customers, I'm going to reduce the cost of your daily meal by $20." Dinner for the ten will now cost just $80.

The group still wants to pay their bill the way we pay our taxes, so the first four men are unaffected. They still eat for free. But how should the other six divide the $20 so that everyone gets his fair share?

$20 divided by six is $3.33. But if they subtract that from everybody's share, then the fifth and sixth man would be paid to eat their meal. So the restaurant owner suggests that it would be fair to reduce each man's bill by roughly the same amount, and he proceeds to work out the amounts each should pay. And so:

The fifth man, like the first four, now pays nothing (100% savings).

The sixth now pays $2 instead of $3 (33% savings).

The seventh now pays $5 instead of $7 (28% savings).

The eighth now pays $9 instead of $12 (25% savings).

The ninth now pays $14 instead of $18 (22% savings).

The tenth now pays $49 instead of $59 (16% savings).


Each of the six is better off than before. And the first four continue to eat for free. But once outside the restaurant, the men compare their savings.


"I only got a dollar out of $20," declares the sixth man. He points to the tenth man, "but he got $10!"


"I only saved a lousy dollar too," exclaims the fifth man. "It's unfair that he got ten times more than me."


"Why should he get $10 back when I got only $2?" shouts the seventh man. "The rich get all the breaks!"


"Wait a minute," the first four men yell. "We didn't get anything back at all. The system exploits the poor!"


The nine men beat up the tenth man.


The next night the tenth man doesn't show up for dinner, so the nine sit down and eat without him. But when it comes time to pay the bill, they discover they don't have enough money between all of them for even half of the bill!


And that, my fellow investors, is how our tax system works. The people who pay the highest taxes get the most benefit from any tax reduction. But tax them too much, or attack them for being wealthy, and they just may not show up anymore. In fact, they might find a place where the atmosphere is somewhat friendlier.


Moral of this story: Never forget the fact that money always flows toward where it is treated best!

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How To Become A Dysfunctional Investor

From the pages of Details magazine we learn that trading on the Iraqi Stock Exchange (ISX) is dangerous, because of limited foreign investment (and unlimited bombs), but the index posted an annual 45 percent gain as recently as 2000. Only citizens and expats can get accounts, but the exchange may open to foreign investors by year-end. The smart money is on financial-service stocks. Down the road, consider manufacturing, construction, and real estate. Eventually, hotels and tourism could be market drivers.

Note: Dysfunctional investors should also consider Zimbabwe, Lebanon and Kazakhstan.

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Speaking of Warren Buffett...

At our monthly get-together in Naperville last evening several comments were made concerning Warren Buffett, and most prominently mentioned was the fact that much of Buffett's success as an investor can be laid to the fact that he is very focused in the actions he takes investment-wise.

But I would submit that it goes even further than simply being focused, it also requires having a disciplined mind that causes Buffett to learn what he needs to know and then to follow through and take the kinds of action that are needed in order to bring about the desired results.

And yet I believe it goes even beyond being focused and being disciplined - it all has its beginnings by possessing a burning desire that will not allow anything to stand in the way of its attainment. And it is at this point that I believe most investors fall short of their investing goals.

Something else also stands out with regard to Warren Buffett, for he is more than merely an investor, he is also an entrepreneur - having transformed Berkshire Hathaway into a mercantile phenomenon. This in turn reveals an interesting parallel: that developing and building an investment portfolio has very much in common with developing and building a business.

This became readily apparent to me from reading a book by Fran Tarkenton, famed football player. The book is entitled: What Losing Taught Me About Winning. This book by the way, has nothing to do with football, but is all about building a business. And in the book, Tarkenton goes on to make several very valuable points that any investor would do well to heed. Among these:

* You have to be self-driven in order to go after whatever it is you want in life.

NOTE: this goes back to what we said about Warren Buffett being focused, having self-discipline, and possessing a burning desire to succeed.


* Money should not be your motivation. The journey is the thing. Climbing the mountain, not reaching the summit, is what you remember and enjoy. It should be the challenge, the competition, and the sense of enjoyment.

NOTE: As an investor, even though you may never find that elusive "10-bagger" that Peter Lynch talks about, you can still enjoy the challenge and the thrill of smaller victories as you improve your investing prowess.


* What stirs your competitive fires? What inner source can you tap into to help drive you and push you into doing what you have always wanted to do? What stokes your fires?... Find it and use it, whatever it might be. Look for those things that get you going.

NOTE: As an investor, you need to harness a desire that will propel you to success, and I can't think of a better one than the desire for Financial Freedom!


* Developing a sense of urgency about pursuing your dreams is vital. And you create that urgency by thinking about the frustrations and the limitations of working for someone else.

NOTE: Likewise as an investor, reaching the "Land of Critical Mass" in which you live off the passive income generated from your investments, and have no further need to work for a living, this is as the late Jackie Gleason would say, "How Sweet It Is!"

* If you are going to successfully start and operate a business, your mind, not your emotions, must rule and dictate actions. The small business entrepreneur has to focus on winning and attaining goals, so that when problems arise they are viewed as challenges to be savored and met rather than insurmountable obstacles.

NOTE: How true this is for investors as well. In order to succeed as an investor, we must eliminate emotions, and allow our minds to rule and dictate our actions.


One final suggestion: In order to succeed as an investor it is necessary to Think CIA: Use your curiousity to fire your imagination and propel you into action.

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Schwab's Stock-Picking Prowess

Charles Schwab & Co. isn't the first name that comes to mind when you think about stock advice. In fact, when Schwab began its computer-driven rating system three years ago, the critics panned it as a mechanistic toy. But lo and behold, in a run-off of brokerages' model portfolios conducted by Zacks Investment Research, Schwab's 100 highest-rated stocks possessed the best three-year track record by a long shot, leaving competitors like Merrill Lynch and Smith Barney in the dust.

From 2002 through 2004, Schwab's recommended list returned an annualized 15%, versus 4% for Standard & Poor's 500-stock index. Credit Suisse First Biston came in a distant second, at 9% annualized. Smith Barney's and Merrill's picks returned a puny 2% per year.

Schwab's stock picking prowess came with the acquisition, in 2000, of Chicago Investment Analytics, a research firm that catered to big money managers. The system Schwab acquired is strictly numbers-driven.

The system looks for attributes that spell future success for a stock. For starters, it looks at the quality of a company's earnings - whether they come from increased sales or more efficient operations, instead of one-time events. In determining value, a low price relative to earnings is important.

To judge sentiment toward a stock, the rating takes its cues from the smart money investors, such as companies that buy back their own shares. Then it factors in signs of risk, such as whether earnings growth has been on a steady track.

Every week, Schwab puts 3,000 firms through their paces. The stocks are ranked and assigned letter grades of A, B, C, D or F. To construct its 100-stock model portfolio, Schwab picks from among the 1,000 largest companies in proportion to the makeup of sectors in the S&P 500. So if a sector makes up 10% of the index, the model generally includes ten stocks from that group.

The top 100 recently included names such as 3M, Barnes & Noble, Cigna, Electronic Data Systems, Valero Energy and Verizon.

Ironically, Schwab doesn't put this 100-stock model portfolio in front of its customers. To learn what's in it, you have to ask a Schwab rep. And if you're not a Schwab customer, then you're out of luck. The list is for clients only.

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The Importance of Dividends

We read in Kiplinger's Personal Finance that historically, approximately 65% of the return on stocks has come from the compounding of reinvested dividends. Beyond the numbers, dividends are the most revealing indicator of a company's success - even better than earnings per share or return on equity.

Companies that raise their dividends consistently tend to outperform the market as a whole. Such companies seem to have found a stable, profitable market niche; a moat, or defensive perimeter around their business that discourages competitors.

With this fact in mind, it is well to note that the average payout ratio among S&P 500 companies is now 32%, which is far below the long-term norm of 50%. Therefore it would appear that there is plenty of "wiggle room" for dividend increases that would raise the future value of these stocks.

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The Case For Stocks

According to Forbes magazine, higher inflation and higher interest rates have arrived, and may not run their course for some time to come. If so, investors should not lose sight of the fact that stocks have proven to be a long term inflation hedge. For example, in 1977-81 during the terrible Carter years, the United States was in the throes of hyperinflation, as prices rose 12.6% per year. And although stocks fell by 7.2% in 1977, over the next four years they gained 12.3% per year, versus 10.8% for inflation. Bonds, meanwhile, experienced price collapses of as much as 50%, placing them in negative territory for that same five-year period, even with interest payments included. Thus stocks turned out to be the better investment back then, and the same is likely to be true now as well.

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A Potential Problem With ETFs

It seems as if new specialized ETFs are being created every week. According to Morningstar, there are now more than 253 ETFs trading on various exchanges - an increase of 101 over a year ago at this time.

The problem I'm reporting on has to do with liquidity. However, this problem does not apply in the case of the older, more established ETFs like S&P Depository Receipts (AMEX: SPY), the DIAMONDS Trust (AMEX: DIA), or the NASDAQ 100 Trust (NASDAQ: QQQQ). These larger ETFs all trade with a daily share volume in the millions of shares.

But what about smaller ETFs like the 1st Trust Dow Jones Internet Index (AMEX: FDN), the Rydex Small-Cap 600 Pure Growth (AMEX: RZG), or Dow Jones Wilshire Large Cap (AMEX: ELR) - all of which have had days when there were zero trades.

Many other ETFs have serious liquidity problems too, with trades of fewer than 10,000 shares a day. And since liquidity also depends on popularity, it is quite possible that some of today's "hot" ETFs may be difficult to unload years from now. So if you invest in an ETF, the best course of action is to check the daily trading volume of any ETF in which you are invested, and don't invest unless the ETF has shown good liquidity in both bull and bear markets.

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The Case For I-Bonds

Sometimes it pays to procrastinate. People who never got around to buying Series I inflation-adjusted savings bonds last winter may have thought they missed a great opportunity when the interest rate plunged from 6.73% to 2.41% on May 1st.

But not so, according to Daniel Pederson, author of Savings Bonds: When to Hold, When to Fold and Everything-In-Between.

The interest rate for I-bonds has two components: a fixed rate that lasts for the 30-year life of the bond plus an inflation adjustment that changes semi-annually, in May and November. Bondholders earned 6.73% for the six months between November, 2005 and May 1, 2006, but the bulk of that was due to the inflation component, which jumped because of last summer's run-up in oil prices. The fixed rate was just 1%.

Although the inflation factor for new bonds has plunged to 1.01%, the fixed-rate component has jumped to 1.4%. So the purchaser of an I-bond is guaranteed 0.4 percentage point more over the life of the bond.

For the past 25 years, inflation has averaged 2.7% annually - which, added to a fixed component of 1.4%, would be equivalent to a 4.1% return on I-bonds. Series EE bonds, currently paying a fixed rate of 3.7%, would be a better deal only if you expected inflation to be lower than average.

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