Thursday, March 28, 2013

Defined benefit or defined contribution? There is a difference.

Unfortunately, my local paper -- the News and Observer, seems a little confused about the difference between a defined benefit plan and a defined contribution plan.

The relevant sentence in the article is:
The discussion comes as state leaders consider a shift from a pension program to a defined-benefit system.
This makes no sense.  The current pension program is a defined benefit system.

Just to be clear:

A defined benefit retirement plan is a plan where the beneficiary is promised a specific financial benefit based on some formula of years served and contributions made into the plan.   A pension plan is an example of a defined benefit plan.

A defined contribution plan is a plan where the beneficiary pays into the plan and gets a financial benefit that depends entirely on how well his/her contributions have grown in value.   A 401k plan is an example of a defined contribution plan.

Thanks to Ron for the link.

Preventing bank runs in Cyprus

Cyprus is the latest Euro-zone country to be teetering on the brink of collapse.  A key problem facing regulators there is the threat of a bank run.   Briefly stated, a bank run can occur when the depositors of a bank all try and withdraw their funds at the same time.  In most cases, they choose to do this because there are concerns about the solvency of the bank.  However, the mere threat of a bank run can be enough to render a bank insolvent.

Which brings us back to Cyprus.   The linked video shows some of the lengths that Cypriot regulators are going to to try to prevent a bank run.

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Bank runs are rare - although we saw one a few years ago in the UK.

Monday, March 25, 2013

Want to increase firm value? Put an academic on the board

Interesting paper that finds that firms with academics on their boards are more profitable.

This research is part of a large literature that looks at the role of the Board of Directors in affecting firm value.  In general this research finds that outside directors (those not affiliated with the firm) provide better governance than insiders.   This paper goes one step further by showing that if those outside directors are B-School academics - the governance effect is even stronger.

Via: Marginal Revolution

Saturday, March 23, 2013

Your portfolio needs fossil fuels - Green Alpha is wrong.

OK - before I get in to this post - I should say that in full disclosure, I am a member of the Sierra Club - I think it is a great organization and I support a lot of their work, but this article that appeared on the "Green Alpha" blog - housed on the Sierra Club website is, quite frankly, a load of ...

Ok - let me back up a bit.   Green Alpha is a socially responsible fund management firm started by the Sierra Club to offer environmentally friendly investment options.   Depending on which product you invest in, you can pay 1-2% management fees (ouch!).

Back to the article - the author claims that investing in fossil fuel companies is a bad idea - from an investment standpoint.   Now I get that the Sierra Club thinks that reliance on fossil fuels is bad for the environment - but are they also bad for your wealth?

If Green Alpha claims that as a socially responsible fund, that they should not invest in fossil fuels - then that's fine, although I do note that they invest in Google, which, in 2011, used as much electricity as would be needed to power 200,000 homes.  But that's a debate for another day.

No, the reason green alpha thinks we shouldn't buy energy stocks is because they argue that Modern Portfolio Theory advocates a portfolio that is better suited to the 1950s than today.
Modern portfolio theory’s asset allocation models were made for and reflect a world where fossil fuels were the only imaginable primary power source.
This is utterly wrong.  MPT's asset allocation models were not made for any specific world.  Heck they'd work in a world where all power came from solar, wind or butterfly burps.   Modern Portfolio Theory states that the efficient portfolio is based on balancing the volatility and expected returns of all available investable assets.   The net result is that the weighting of each asset class in the "optimal portfolio" is that asset's market value.  MPT says nothing about green energy, or fracking, or hybrid cars.

To argue that MPT is somehow flawed is really a feeble attempt to justify an investment strategy that only invests in a subset of assets and then charges very high fees for doing so.

By investing in a subset of stocks, you are going to increase your risk without getting a corresponding increase in return.  In effect, you are giving up some diversification.   This might make you feel better about yourself, but it won't help the Polar bears, and it certainly won't help your retirement portfolio.  On top of that, you are likely to pay way too much in fees for this suboptimal portfolio.

My advice:  If you care about the environment - index (and yes, hold energy stocks), but bike to work from time to time, turn down your thermostat a bit and even donate to the Sierra Club.

The case for passive investing

This is a great video advocating for passive (or index fund) investing.   The film is made for a UK audience but is applicable to anyone who invests anywhere.  

While the film was funded by an investment management firm, it is accurate and not misleading.  The points they make are correct and are borne out by the academic research.

Finally it is worth watching just because you get to see some of the big names in finance - Jack Bogle, Ken French, David Booth (Chicago B School named for him), and of course Bill Sharpe - the guy who developed the CAPM and got the Nobel.

Via: Reformed Broker

Wednesday, March 20, 2013

Mutual Fund Fees - You get what you don't pay for...

Simple, clear, video on the evils of mutual fund fees.

Market Timers and Asset Allocators

Here's interesting blog post about the returns from market timing - the art of getting into the market before it goes up.  

While we can always show that if you can time the market, you could make great returns, the reality is that timing the market is near impossible to do - even if you pay attention to overall market fundamentals.   Case in point:  In 1996, all the fundamentals indicated that the tech market was very overheated and yet the bubble didn't burst until 4 years later.

Therefore, it is pretty safe to say that in the long run, the average returns of a market timer will always lag those of someone focusing on steady asset allocation.

Wednesday, March 6, 2013

Dow Jones - record high?

The "big" news yesterday was that the Dow Jones Industrial Average closed at a record high.  While this is an attention grabbing headline - it is actually pretty meaningless.  

The Dow Jones Industrial Average is a price weighted index.  In short the index is computed by adding up the prices of 30 big stocks and then dividing them by a number called the divisor.   As a result, the index only measures changes in prices and is based on a very arbitrary computation.  

A better way of measuring the performance of the Dow Jones stocks is the Dow Jones Industrial Total Return Index which includes dividends paid on the stocks.

We can see the difference quite clearly:

The blue line is the total return index.  I've shown them both from the last record level of the price index which was October 2007.   What is clear is that the total return index beat its previous record around the end of 2011.  To date it is up 20% since then.  

This clearly shows the importance of dividends in computing a return and why just looking at a price index is really pretty pointless.