Wise Investing Made Simple by Larry Swedroe

I’ve been getting back into reading financial books, but am really behind in writing reviews for them. One book I finished last month was Wise Investing Made Simple by Larry Swedroe, which promises “Tales to Enrich Your Future”.

The key word is “tales”, because this is not a book with complex mathematical formulas or lots of charts and statistics. (Although I love charts…) It contains 27 short stories using simple concepts like sports analogies to explain the benefits of a long-term, passive approach to investing. Each story includes a quick “Moral of the Tale” summary.

I’ve already written about my favorite tale in Why Sports Betting and Stock Picking Are Similar. But here is my paraphrasing of another good chapter:

The $20 Bill
Here’s is a common story used to poke fun at the Efficient Market Hypothesis. An economist who believes in efficient markets walks down the street with a friend. The friend says “Look, there’s a $20 bill on the ground!” The economist says “No way. If there was a $20 bill on the ground somebody would have already picked it up”, and continues to walk away. This supposedly counters the idea that in a truly efficient market it would be impossible to find an under-priced stock (similar to a $20 bill priced at $10 or even free).

However, this argument is not really correct. What the story eventually explains is that while many passive investors believe that the occasional $20 bill on the ground may exist, spending your time looking for them may not be the most effective way to make money. The same could be said about stock-picking or market timing. Persistence in beating the market (finding $20 bills) beyond the randomly expected is very difficult to find.

Summary
For the investor that is already committed to passive investing and fully understands the underlying reasons why they believe that is the best strategy for them, this book probably won’t bring that much new to the table. It won’t help you decide whether to hold 20% International or 45% International stocks, or if you should include exposure to commodities or precious metals. If you are a full-time trader who is adamantly against passive investing, this book probably won’t contain enough hard facts to sway you either.

Instead, I think the sweet spot for this book are those investors that have been told “index funds are great” and may even invest in them but don’t really know why they are so great and don’t have the interest level to read some dry investing book about correlations and standard deviations. The problem with this level of understanding is that when things get tough it can be easy to bail out if you don’t really know why you’re doing something. This book breaks things down into simple, bite-size pieces without being patronizing.

On a personal level, this book might not be the very first book on saving money I’d give someone, or my favorite book about investing, but I am going to keep it in my library because it provided some different ways to explain to others (and myself at times) why I invest the way I do.

Overall Rating: (ratings explained)

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Your Money, Your Brain, and Your Happiness

In the book Your Money and Your Brain, author Jason Zweig explores neuroeconomics, which apparently is a mix of psychology, neuroscience, and economics. This book looked like it would be an easy read, but it turned out to be very densely packed with information and data from numerous psychological studies. Truth be told, it got kind of tedious and repetitive, which is why it took me over a month to finish reading it. I think more aggressive editing would have helped this book a lot.

Instead of trying to do an in-depth review, I’m just going to focus on a few interesting points brought up in my favorite chapter titled “Happiness”. Isn’t being happy our ultimate goal?

If I was rich… I’d be happy. Right?
When you are below the poverty line, then yes, making more money is correlated with happiness and even better health. But as long as you have enough to meet your basic needs, more money doesn’t buy very much more happiness. We think it will, but it reality it doesn’t. This has been shown in studies comparing African tribal herders with the Forbes 400 Richest People, ones comparing people with $500,000 net worth and those with $10M+ net worth, and even between different generations of Americans:

In 1957, the average American earned about $10,000 (adjusted for inflation) and lived without a dishwasher, clothes dryer, television. or air conditioner. But 35% of people surveyed said they were “very happy” with their lives. By 2004, personal income had nearly tripled after inflation, and the typical house was bursting with consumer goods. Yet just 34% of people now said they were “very happy”. Somehow, almost tripling our wealth has made Americans a little less happy - and still we want more.

Chasing Happiness
Similarly, people think that “splurges” or getting that next hot gadget will make them happy. In truth, studies reveal that the anticipation of obtaining that object makes your brain’s dopamine levels go nuts and you feel happy. Actually getting it? Not so much. Which leads you to thinking about the next hot gadget… and so on. The “thrill of the hunt”, eh?

Keeping Up With Those Darn Joneses
It turns out that your happiness is related money in one way - how much money the people around you have! Social comparison is a very primal instinct in humans and other animals. One theory is that such attention allowed people to imitate the stronger hunters and learn to be more like them.

For example, should you buy the nicest house in a middle-class neighborhood, or a below-average house in the richest neighborhood? Your real estate agent might point out that buying in the rich neighborhood offers the best potential for home value appreciation. But the data suggests that buying in the middle-class neighborhood and getting a bigger house than everyone else will likely make you happier.

A study of more than 7,000 people in over 300 towns and cities found that, on average, the more money the richest person in your community makes, and the greater number of neighbors who earn more than you, the less satisfied you will probably feel with your life.

The relationship between money and our brains is an interesting one. It’s good to learn about those innate tendencies, so we can recognize them and react appropriately.

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Unconventional Success: Investing in Core and Non-Core Asset Classes

One of the books I am currently reading is Unconventional Success: A Fundamental Approach to Personal Investment by David Swensen. He is a very successful institutional money manager, having guided the Yale University Endowment to over 16% annualized returns over 20 years. While he has already written a bestselling book about institutional fund management, Pioneering Portfolio Management, this newer book outlines his investment advice as tailored for individual investors. I’m not finished with it yet, but so far I am very impressed. This is one of the few people in the world who could easily say “Here’s how anyone can beat the market!”, but instead he presents a unique argument for building a portfolio using low-cost, diversified, passive components.

One of the ways he separates himself from others is his definition of “core” asset classes in which to invest. Briefly, core asset classes share three main characteristics:

1. They rely on market-generated returns, not from active management skill (as it is a very rare attribute and hard to separate from luck).
2. They add a valuable and differentiable characteristic to a portfolio.
3. They come from broad, highly-liquid markets.

The six core asset classes he identifies are:

Domestic Equity
Foreign Developed Equity
Emerging Market Equity
Real Estate
U.S. Treasury Bonds
U.S. Treasury Inflation-Protected Securities (TIPS)

These are all pretty well-accepted asset classes. The surprise comes when he tells you where you shouldn’t invest. Here are the non-core asset classes which Swensen believes fail to satisfy one or more of the criteria above:

Domestic Corporate Bonds
High-Yield Corporate Bonds
Asset-Backed Securitiesl (like GNMA mortgage-backed bonds)
Tax-Exempt Bonds
Foreign Bonds
Hedge Funds
Leveraged Buyouts
Venture Capital

Many of these asset classes are very popular! Take corporate bonds. While I can’t present the argument nearly as well here, the basic idea is that they don’t satisfy the “valuable and differentiable” requirement above. People buy corporate bonds over Treasury bonds because they can get a higher yield. But Swensen argues that the slight premium is not enough to compensate for the additional credit risk, lower liquidity, and callability of such bonds. One source of this imbalance is the fact that the interests of the bond issuer (the corporation) are inherently at odds with the bond investor. The corporation wants to minimize the cost of it’s debt, while the bond holder wants the opposite. Compare this with the situation of a stock holder, where both want the company share value to increase.

Possible Portfolio Changes? If you invest any bond mutual funds, you may want to find out what percentage of those funds are in corporate bonds and asset-backed securities. For example, the Vanguard Total Bond Index fund (VBMFX) holds almost 45% in mortgage-backed bonds and only 35% in Treasury bonds. Of course, many young folks don’t have any bonds at all, so this may be a low priority.

Personally, my small bond allocation is 100% in corporate bonds. I always thought that bond markets were very efficient in dealing with credit risk, and that duration and sensitivity to interest rates mattered more than the type of bond. I will have to do more reading on this topic, but it may be more prudent to switch to Treasury bonds/TIPS and instead take any additional risk by adding more equities exposure.

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The World Is Flat: Book Review and Commentary

I’ve been chipping away at it for months, and finally finished Thomas Friedman’s The World Is Flat: A Brief History of the Twenty-first Century. By a flat world, he means that the playing field is being leveled and the gap between emerging and developed countries is closing faster and faster. For many people this means the fear of losing jobs to outsourcing, but it’s actually a lot more than that.

Flat means less friction. Yes, less friction for jobs to go back and forth across the world (usually away from the US). But the same holds true for people, money, ideas, and even cultures. He says this is caused by the “triple convergence — of new players, on a new playing field, developing new processes and habits for horizontal collaboration.” We can either look at this loss of friction as a bad thing and try to ignore it or keep it from happening, or we can realize that it is inevitable and work to take best advantage of it.

Up to now, many of the best jobs were here, and you had to live here to perform them. But thanks to new technology like the internet and computers, as long as someone is able to learn the same skills, they can do it from anywhere. This varies from the familiar cheap manufacturing of goods and telephone support, to highly skilled jobs like corporate accounting, computer chip design, even medical procedures.

Up to now, the best education was here. To me, this is critical, and I don’t think people realize it enough. Historically, we have had the most advanced and desirable graduate schools in the world. While in grad school, just in my building alone, I was surrounded by the top students from Germany, India, China, Taiwan, Brazil, and Russia. I’ve heard their stories about having to be the top 0.01% in their country just to get here. The vast majority of these people ended up getting jobs and settling down in the US. If you look around, first-generation immigrants anchor many of the research arms of all our major corporations. Microsoft, GE, Genentech, Google…

In other words, this country has been skimming off much of the smartest and most driven people in the world for ourselves. That’s a pretty sweet deal. But as I type many countries are working feverishly to make their own educational systems better.

If another country has a similar or better educational system, and their workers can do it for less, you can bet the job will be moving there. Patriotism, protectionism, or whatever - it’s still fgoing to happen. This means that we need to work to improve our own education systems and get rid of any sense of entitlement. Soon, simply being lucky enough to have been born in the US won’t be enough.

The book touches on many more topics than this, and I don’t even claim to understand all of it. I’m not an economist nor am I much of a historian. Although Friedman overall is a great storyteller and good at explaining complex ideas, there are also several slow and repetitive parts that literally made me fall asleep while reading it.

Conclusion
In the end, The World Is Flat reminds us that we are all in constant competition with each other. Before, it was your neighbors across the street. Now, it’s anyone with internet access. While it is not a zero-sum game (there is not a fixed number of jobs), there will be people who do better than others. As Americans, we are being chased. Our choices are either to run faster or risk getting left in the dust. Just making us consider such a possibility is a good result from this book.

How you think this competition will unfold can also alter your investment strategy. I still haven’t made any conclusions regarding this, but have been considering simply weighting my investments in proportion to the value of the world’s companies (i.e. using a world market cap-weighted index).

Overall Rating: (ratings explained)

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Nothing Down For the 2000s: Real Estate Book Review

I’m naturally skeptical of most real estate gurus, with all that feel-good “You too can be rich!” talk and very little substance. Still, I was curious to see what was inside Robert Allen’s best-selling book Nothing Down for the 2000s: Dynamic New Wealth Strategies in Real Estate. As you’ve probably guessed, it’s supposed to be about getting rich by investing in real estate with none of your own money.

If you cut out the copious amounts of go-change-your-life fluff in this book, it boils down to two main ideas:

Buy below market price by finding a “don’t-wanter” seller. A “don’t wanter” is someone who is going through some sort of trouble so that they don’t have the time or ability (or intelligence) to get market value for their property. Maybe they can no longer support the payments and are almost in foreclosure. Or they are tired of property management headaches.

Use creative mortgages to buy the property with little or no down payment. Then sell for a profit. Lending ideas included:

1. Getting the owner to finance the house, so you pay them a mortgage each month instead of the bank.
2. Using interest-only mortgages to minimize the monthly payment while you try to flip the house.
3. Do 110% financing where you borrow more than the value of the house, and take the rest out in cash to cover the down payment (or buy another property)
4. Use a loan backed by Property #1 to buy Property #2.
5. Use credit cards or signature loans from the bank as a down payment.
6. Buy an apartment complex right before rent is due, and use the rent and security deposits as a down payment.

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The Automatic Millionaire Homeowner: Book Review

David Bach has sold a lot of books under his “Finish Rich” and “Automatic” titles. Most of his books seem to be heavy on the inspirational talk and light on the specifics, but I think that’s actually what has helped them sell so well - they are targeted for beginners.

Case in point, I wasn’t very impressed his earlier book The Automatic Millionaire (review), but as a home-buying neophyte I found a lot of useful information in The Automatic Millionaire Homeowner. Sure, he recycles a lot of his “make it automatic” mantra when talking about saving up for a house down payment (set up automatic transfers to a online savings account) or setting up a bi-weekly mortgage repayment plan (set up automatic transfers with your lender), but you can pretty much just skip over those parts.

Besides all the automatic-talk, what this really provides is a brief overview of the home-buying process. Think of it as “Home Buying For Dummies”, but even shorter. From finding a real estate agent, to finding the right loan, to finding the right home. The writing is clear and well-organized. It promotes long-term homeownership, and is not at all about flipping properties. However, if you’ve already gone through the process once, the book will probably bore you to death.

The main weakness in the book is that it focuses on the upsides of homeownership without fairly discussing all the potential downsides. It’s very “rah-rah”, you can almost imagine David Bach wearing a cheerleader’s outfit complete with pom-poms:

“I say BUY, you say HOUSE!” “GO REALTORS GO!”

(I added the Wells Fargo logo as he is sponsored by them.)

Conclusion
I would recommend this book for first-time home buyers, as it provides some helpful information. But, I would not recommend it as the only book to read, as it is doesn’t address the pros and cons as fairly as possible.

Overall Rating: [ratings explained]

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My Recommended Reading List For Investing

While there is a ton of great financial information on the internet, I still think the best way for a beginner to learn how to invest is to read a book. It’s by far the most efficient way to understand all the history and research behind why people like me promote low-cost index fund investing. The more you know, the less you’ll be tempted to pay high fees or chase hot stocks.

By my count, I have read and reviewed 24 financial books so far. Here are my picks. They would make a great gift or simply provide some useful reading during holiday downtime. I own all of these books, and they were some of the best money I’ve ever spent.

Best Beginner Personal Finance Book

The Richest Man in Babylon:Short and very easy to read. Teaches the merits of living below your means and investing the rest for the future. [my full review]

Best Starter Investing Book
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Index Funds: The 12-Step Program for Active Investors - Book Review

Almost a perfect counterpoint to The Little Book That Beats The Market (review), this book could easily be titled The Big Book That Shows You Can’t Beat The Market. It weighs nearly 5 pounds, and is almost 400 pages long. This thing is a beast!

Instead, the title is Index Funds: The 12-Step Program for Active Investors. This is actually a pretty good title as well. Instead of starting at the pure beginner level, it assumes that you know a little bit about the market. Maybe you’ve dabbled in stocks, or have some hot mutual fund picks on your 401(k). The basic layout of the book is this:

1) Present an active-trading idea, and then
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The Little Book That Beats The Market: Book Review

There’s been a lot of buzz about The Little Book That Beats the Market, so I was excited when it finally came in from the library. Of course, at the time I was midway through Index Funds: The 12-Step Program for Active Investors, which I’ll also be posting a review about shortly. Alternating between the two books was like a roller coaster - the Little Book fanning the (little) stock-picking flame inside me, and Index Fund book trying just as hard to stamp it out forever.

The Little Book is well, really little. It’s about the size of a 5″x7″ photograph and barely over 100 pages long. It could be easily finished in one afternoon. The writing style is simple and easy to read, although many of the jokes felt a bit forced to me.

It starts with a nice little story which explains what you are actually buying when you purchase a stock. In short, you’re not buying a physical object, but a stream of future earnings. This is why stock prices fluctuate so much - you’re trying to predict the often-hazy future.

Accordingly, Greenblatt argues that the Market is simply crazy over the short term. But due to this craziness, there is the opportunity to snap up a company at a bargain price. Enter the Magic Formula: Buy good companies at bargain prices. Doing some number-crunching, using the formula gives you historical annual returns of about 30%, beating the market by 20% every year. All with lower risk than the market. Yowza! Sounds good right?

The tricky thing about this book is how ‘good’ and ‘bargain’ are defined. Greenblatt uses a vague definition in the main part of the book, and then a more complicated definition in the appendix. Thanks to JLP at AllFinancialMatters, I discovered this Barron’s article which confirms that even other quantitative people can’t understand the exact definition of the Magic Formula or replicate his awesome returns. They used a different stock database, leading to the returns going down significantly. That’s a bit fishy.

But… even if you use his dumbed-down (my name, not his) definitions of:

Good = High Return On Assets (ROA), and
Bargain = Low P/E ratio,

both of which are part of most stock screeners, you still get market-beating results.

Criticisms
Any time a book claims to beat the market, people line up to crap all over it. I mean, isn’t this just good ole’ Value investing? Traditionally this is done with other ratios like Book-to-Market ratios. Again, the data seems to support that the Little Book method does better than other ratios.

Another criticism, which is noted in the book, is if everyone knows this secret, won’t the prices adjust and remove this market inefficiency? Greenblatt counters this with the fact that his method only works for the long-run, and will underperform the market for sometimes years at a time. This volatility will scare away enough investors and/or fund managers over the long haul such that the premium will endure. Okay, maybe.

My personal nitpick is that the returns also don’t take into account trading commissions and bid-ask spreads. Greenblatt glosses over this point by implying “This method kicks so much ass (remember, 30%!) that you could pay full-service broker commissions and you’d still come out ahead!”

But let’s take a closer look. He suggests holding 30 stocks, each for only a year. Unless you’re investing huge sums, that’s a big drag. If you buy in $500 chunks ($15,000 total portfolio size) with $10 trades, that’s a 4% dent in profits every year (buy and sell). Even at $5 trades, that’s 2%. Finally, if you’re not holding these in an 401k/IRA, you’ll have to deal with taxes.

Added:
1) His returns were based on data from 1988 to 2004, which may be the best he could get will full data, but still is less than 20 years. Will it persist?
2) The book has a website, MagicFormulaInvesting.com, which you can generate the current picks per the Little Book method.

Conclusion
So, if you add in the database inconsistencies, smaller future market inefficiencies, the existing value-premium, the trading costs, and taxes, will you still end up with a risk-adjusted market-beating return for the next 20 years? I have no clue. I can only say that I’m not changing any of my current investments, but if I do eventually set up a small stock-picking portion of my portfolio, I’ll keep the results of this book in mind.

Although I don’t really recommend it as an investing guidebook like The Four Pillars of Investing, I did find it a fun book to read. I think it presents a new-ish view on picking stocks and was a refreshing change of pace for me.

Overall Rating: (ratings explained)

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Book Review: The Big Money - Seven Steps to Picking Great Stocks and Finding Financial Security

The Big Money by Frederick R. Kobrick, was also sent to me for review. It was good timing because I was looking for books on stockpicking to expand my reading horizons. One can only read so many books on the wonders of index funds before monotony sets in.

I’d never heard of Kobrick before this book either, but apparently he is a long-time mutual fund manager with accolades such as:

- Manager of the State Street Research Capital Fund, which was ranked as one of the top five mutual funds in the country for the entire 15-year bull market in 1997
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Book Review: Yes, You Can Still Retire Comfortably!

After reading their investing book Yes, You Can Time The Market! and liking their writing style and slightly different view on things, I decided to read Ben Stein and Phil DeMuth’s book on retirement - Yes, You Can Still Retire Comfortably!

Even though this book is targetted at Baby Boomers worried about their impending retirement, and I’m still in my 20s, it was an interesting read. First, they scare you with (true) tales of underfunded pension plans, a shaky Social Security system, and rising healthcare costs. Obviously, you need to do something about it!
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Book Review: All About Asset Allocation

Recently, I have been avoiding reading more investing books that were basically ‘invest in index funds, invest in index funds, invest in index funds’. Great message, but I get it already. I wanted a more detailed analysis of the different asset classes, and more advice as to what to actually buy. And so I found All About Asset Allocation by Richard Ferri, which does exactly that.

The beginning of the book starts like most other index fund books: great investment skill is very rare, asset allocation determines much of your investment return, expenses matter, and you should invest for the long term. The book also explains (better than I can here) how asset allocation works by reducing your overall portfolio risk by introducing asset classes that have a low correlation to each other.
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Book Review: The Intelligent Asset Allocator

The Intelligent Asset Allocator (IAA) by William Bernstein does exactly what it says on the cover, it teaches you ‘how to build your portfolio to maximize returns and minimize risk’. However, I would recommend that 95% of readers not buy it. Come again? Instead, I would recommend the later book by the same author, The Four Pillars of Investing (review). Even though Bernstein himself refers to it as for the ‘liberal arts’ audience, I have an engineering background and I still like Four Pillars much, much more. It just feels more refined and easier to follow.

Both books seem to cover the same general topics, with IAA giving you a clearer mathematical basis for his conclusions. To me, here are the main ideas within the book:

1) There is very little evidence that, on the whole, actively managed funds outperform the market. In fact, if you just buy what’s been hot the last 5 years, history has shown that you would consistently underperform the S&P 500 afterwards. In other words, don’t chase past performance.

2) As risk increases, so does the return. But that doesn’t mean you should just go out and buy the one riskiest thing you can stomach. Your goal is to get the maximum return out of your acceptable amount of risk.

3) To achieve the goal in #2, you must construct your diversified portfolio out of multiple asset classes which will work in combination to reduce risk. The vast majority of your returns come from your asset allocation mix.

4) You can’t guarantee your future returns, or expect them to follow historical returns exactly. What you can do, is to optimize your portfolio using that data to give you the best chance at achieving the highest returns.

5) Minimize expenses and taxes by choosing no-load index funds with low expense ratios, and by carefully placing each asset where it will be most tax-efficient (taxable vs. tax-deferred accounts).

Finally, in the end, the book gives you some advice on how to choose your specific asset allocation and then implement it using Vanguard or DFA funds. Again, I found the same section in Four Pillars to be easier to follow, and I’ve found myself referring back to it instead of IAA to plan my portfolio.

Summary
Read Four Pillars of Investing first. If you like things like standard deviations and statistics, then pick up The Intelligent Asset Allocator. They are both excellent books, with different approaches to teaching the same material.

Overall Rating: (ratings explained)

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Ponzi : The Legend Lives On

Ponzi scheme. You’ve most likely heard of the term, although you may not know exactly how it works. A Ponzi scheme is a scam where investors are promised amazingly high returns on their money based on some ’secret super-investment’, but in reality the money to pay older investors is simply taken from the money of new investors. Of course, this can’t go on forever, and the investors involved at the end are usually left with nothing.

Let’s take the most recent ‘investment program’ which reeks of being a Ponzi scheme, 12DailyPro, which is now being investigated by the FBI. The story of this interested me so much I started reading ‘Ponzi: The Incredible True Story of the King of Financial Cons‘. The similarities between his story and 12DailyPro are astonishing.
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Dave Barry Does Personal Finance Advice

How do you know when there’s too many personal finance books out there? When comedian Dave Barry does one. In his new book Money Secrets: Why Is There A Giant Eyeball on the Dollar?, he pokes fun at corporations, Suze Orman, and everyone else.

He shares such gems as the solution to soaring college costs: Don’t let your kid study too much, so they can’t get into private school. State schools are much cheaper. Just like the gurus, he’s got a financial assessment quiz for you, with questions like:
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