How to Pick the Investment Strategy that's Right for You

Your most important investment decision is whether to pursue an active or passive investment approach:

With active investing your odds of succeeding range from 0 to 10%. With passive investing, your odds of winning are about 90% after taxes.

So which is right for you?

You can think of active investing as the classic "Buy Low and Sell High" investing strategy. It sounds right until we realize that we are buying and selling from other people who also think they are making a smart decision. And normally these other people -- the ones we are buying and selling from -- are very smart, capable and hard working. We've entered what economists call a zero sum game. In order for one party to win, the other must lose. Then it gets harder. It's not just a matter of half the players winning and the other half losing. Because buying and selling costs both money and taxes, many more people lose than win. After considering transaction costs, about 30% of the players win. After taking out taxes as well, the number of winners falls to 5% - 10%. The rub, however, is that if you do win with active management, you will make more money.

Passive investing is typically a "Buy and Hold" investment approach. It emphasizes diversification and keeping your investments for the long term -- usually decades. The beauty of this approach is that you don't need a sucker at the other end of the trade. Everyone who invests this way can win because as the stock market grows along with company earnings, everyone's investments go up. Because you are not buying and selling, your costs and taxes remain very low.

No one can tell you which approach to take. The answer depends on your appetite for gambling and whether you believe that the 5-10% who win are there by luck or skill.

Said another way: With a $1 million investment, would you prefer a 10% chance of making $120,000 or a 90% chance of making $100,000?

So - Is it safe to buy?

A month ago people were asking if they should sell. Now they are tentatively asking if it’s safe to buy. Why the change of heart? It’s fairly obvious - In the last 30 days or so the stock market is up about 20%. Investing seems a lot safer – as well as a lot more fun - when the market is going up.

So, is it safer to buy after the market has gone up for a month? Actually, yes – at least a little bit. When the stock market is up over a month, there is about a 63% chance it will be up the next month. This compares to only a 58% chance of making money after a down month.

Does this mean you should back up the truck now that the market is up over 30 days and then dump it all after the next down month? After all, a 63% chance of success is better than a 58% chance of success.

Probably not a good idea. Even ignoring how taxes and expenses would eat up the 5% probability difference, you are still almost as likely to lose money as make money. However you look at it, investing on a month- to-month or even year-to-year basis is very risky. There is no way around the reality that you have a very strong chance of losing a lot of money.

Over a 20 year period, however, the stock market becomes a lot safer. If you commit your money for the whole 20 years, you have a better than 95% chance of making money – and that’s a conservative estimate. Including the great depression, there has never been a 20 year period where stocks have actually lost money.

In the end, safety in the stock market comes not from when you buy or sell, but from how long you stay invested.

Madoff-Proof Your Money

Bernie Madoff is the latest in a long list of criminals, large and small, who have stolen trusting investors' money. So how can you protect yourself from someone stealing your hard-earned nest egg? It's actually really, really easy.

Only put your money in an account that has your name and only your name on it. And don't give anyone besides you (or trusted family member) the right to withdraw the money. Make sure the account is at a major firm.

If you want to have someone else manage your investments, you can still do this. Simply open up an account - in your name - at a brokerage firm like Fidelity or Schwab and then give the investment adviser the power to invest for you but not take the money out. You give this by signing over a Limited Power of Attorney - never a full power of attorney. That's it.

Put another way - if someone asks you to deposit money in any account that does not have only your name (and maybe your spouse's name) on it, just run the other way. He's probably a criminal.

Disclaimer: The above should go a long way towards protecting your money. However it is not guaranteed and your money cannot be considered 100% safe from theft. Neither I, Robert Horowitz, nor my firm Robert V Horowitz, LLC can be held liable for any theft.

So, Should I sell?

Everyone seems to be asking this question. And usually getting the same very unsatisfying answer of "No, you need to ride it out for the long term" blah, blah.... I was caught on TV saying the very same thing. Its an over simplistic, sound bite response. In answering "Should I sell", we really need to address at least 3 questions:
1. Should I sell a portion? The depends on whether you have enough safe investments (money markets, cd's, savings account or short term plain vanilla bond funds) set aside to cover the next 3 years of living expenses. If you don't you probably need to sell enough to build up a 3 year emergency fund or have another fall back plan. With unemployment above 8% and probably heading towards 12%, there is a reasonable chance of facing extended unemployment. If you are retired, you should always have at least 3 years of expenses set aside.
2. Should I sell everything and just move on with my life? Only if you are planning to sell forever. This makes sense if you've decided that you simply don't want to live with the risks of the stock market. Put all your money in inflation protected bonds or short term municpal bond funds and never worry about it again. This is a perfectly reasonable, albeit not very profitable, long term strategy. The other reason to sell forever is is that you believe that this is the end of global capitalism, the end of America as a powerful player in the world and that we are entering a period which will make the Great Depression look like a picnic.
3. Should I sell and then buy back later? This is what most people want to do - skip the losing money part and get back in for the fun making money part. Its what the financial advisory world calls market timing and its far riskier and more difficult than it appears. Far from reducing risk, market timing usually increase risk as the hapless investor gets caught in a cycle of buying high and selling low. If this is your motivation, you are almost certainly better off just riding things out.

We are probably living through the greatest investment opportunity in our lifetimes. Consider that here have been two 19-year periods during the last 80 years in which the real returns from stocks was zero. One started at the peak of the market in 1929 and the other at the peak in 1965. The current bear market started in March 2000. To simply equal the zero return of the two earlier 19-year periods, stocks will have to more than double during the next 10 years. I believe they will do a lot better than that and should at least triple in value. So, for most long term investors, the best advice is to hang on and ride it out.

The Canary in the Coal Mine

The stock market is down over 20% so far this year and that is very bad news for the economy. The stock market leads the economy - what happens in the stock market, happens in the general economy around 6 to 12 months later. So with this year's slide, we can be fairly sure that the forecasts for the economy - and unemployment - to bottom out in late Summer were excessively optimistic.

What do things look like now: Unemployment is now running at around 8%. Its looking like that number will get to around 12% later this year - that is a huge amount of jobs lost. To put it in perspective, think of all the people you know who have lost a job in the last year. Now double that number. That is how many people are likely to be unemployed by year end.

Since no-one is really immune, its a good idea to have a "Plan B" in case any of us are among the unfortunate 12%.

Index funds win again

Yet another study confirms that investments in index style funds beat hedge funds and mutual funds run by supposed investment geniuses - by a shockingly wide margin. This is especially true for wealthier investors paying taxes at the highest levels. Mark Kritzman of Windham Capital Management shows that for a New York State taxpayer, an index fund returning just 10% annually beats a typical hedge fund returning 19% per year and an active mutual fund returning 13.5% per year. The results are even more startling in California where we pay a state tax of 9.25% (and growing) compared to NY State's 6.85%.

This means that a hedge fund would need to beat the index fund by 10 percentage points every year and the active fund by 4 percentage points. Finding such funds is almost impossible since so few exist. And the very few that do have a record of winning by such wide margins are almost certainly there by luck.

Once again we find that on Wall Street, the bigger the story, the worse the results.

Business week ranking

Business week just included me in a list of the top 50 independent financial advisors . I'm about midway down the list.

The Obama Mortgage Plan

Its a mixed bag:

Essentially the plan makes it a lot easier for people who have equity of less than 20% and are having trouble making their mortgage payments to refinance at very favorable rates. As expected there will be income limits on the borrowers and the loans must be conforming loans. The hope is this will keep more people in their homes and also put a floor under housing prices.

The problem is that this is not just about the government bailing people out, its about the government forcing lenders to renegotiate mortgages in a way that lenders would not do on their own. While this may keep some people in their homes - a very good thing - it will also raise lending costs for the rest of us. Banks will need to start charging more for their loans simply because now they need to worry that the government may force them to renegotiate on unfavorable terms. Yes - its only banks who took TARP money but even healthy banks were forced to take the money so that there would be no stigma attached to being bailed out (less of a stigma?)

What this means is that the overall cost of loans will go higher not lower - exactly what we don't need. The question - as yet unanswered - is whether the benefit of the subsidized refinancings will outweigh the higher lending costs that the rest of us face.