Good reading from around the Web.

I Ctrl+C copied the URL of an article on Oblivious Investor this week to forward it to my co-blogger, The Accumulator, only to open up my email folder and find he’d already emailed it to me.

After that, it wouldn’t only have been rude if I hadn’t made it my post of the week. It would probably have been bad luck!

In the article, the site’s guest blogger highlights a new breed of ETF that delivers returns based on the spin of roulette wheel:

Index roulette ETFs, such as Roquefort’s ROQ, simply bet on red and black equally. Roquefort uses random numbers generated by a proprietary atomic decay device, and cites academic research that claims this reduces the standard deviation compared to traditional selection methods.

Roquefort also offers two chromic strategy ETFs: REDS, which always bets on red, and BLAK, which always bets on black. Stoker notes that these are riskier: “Be sure you know which color you like before investing.” Roquefort has just introduced OO, which bets on the double zero. The potential for 3500% returns is attractive, but Roquefort notes that due to volatility it may not be suitable for all investors, only for better-than-average investors like you.

There’s plenty more in that vein. Obviously (I hope!) it’s a satire of spurious investment products created to be sold, not to deliver returns.

Sticking with gambling, long-time Monevator reader Niklas Smith highlighted an academic paper that considered whether poker was skilful or not. The researchers argue poker is not gambling, because a small subset of skilled players competing in the 2010 World Series of Poker achieved positive returns, at the expense of less skilled losers.

Niklas highlights the fun bit for our adventures in investing:

The economists say that similar tests of persistence in returns have also been used to detect whether mutual-fund managers have genuine expertise. In contrast to the case of poker, they point out, those tests have tended to find “little evidence of skill in this domain”.

That means that you can’t reliably choose a fund manager who will outperform the market, but you can choose a poker player who will outperform. Perhaps it’s time to start demanding fund managers and investment advisors get lottery licences?

Alternatively, perhaps fund managers should be forced to call themselves exciting poker-style names like Volatile Vince, Leveraged Lucy, Double-Dip Dave, and Dave ‘The Churn’ Dudley.

[continue reading…]

One of the troubling trials the rich face is deciding when to dial back on wealth accumulation to focus on wealth preservation.

Icarus flew too close to the sun, and plenty who’ve made fortunes have lost them, too, when instead they could have lived out their days like Scrooge McDuck in a bathtub filled with dollar bills.

Much too young

On the other hand, given how quickly life expectancy is increasing (though not quickly enough for me!) and the ease with which a champagne (or even a cava) lifestyle can become an everyday habit, others adopt excessively conservative strategies too soon.

Perhaps the young-ish and rich-ish are not as greedy as they’re cracked up to be? I’ve known high-flying 30-something investment bankers to keep their money entirely in cash, bonds, and their West London property. Not a share in sight!

Sometimes they blame the onerous trading rules of their firms, but that’s hooey. The truth is once they’ve made their ‘nut’, they want to squirrel it away, as opposed to correlating their net worth even more with their market-related jobs.

You’ve got to lose to win

Protecting what’s yours may be sensible when you’re raking in six-figure bonuses each year. Didn’t Warren Buffett say the first rule was not to lose money? ¹

True, but you and I aren’t made men at the last Wall Street bank standing, and you’re probably not Warren Buffett, either. Buffett can apply his loss-avoiding rule by spotting a final puff in an investing cigar butt. We mere mortals have to open cash ISAs to play safe, and that will hit our returns.

Most of the past decade was unusually kind to cash savers. But over the long run, history is clear — if you’re aiming to grow your way to wealth through modest savings and compound interest, then you need to forsake the short-term preservation of wealth for the potentially higher rewards (but greater volatility) of equities.

To give a simple example of how you could split a portfolio and expect very different results, according to Moneychimp’s standard deviation calculator:

• A 75% cash / 25% equity split predicts a return of 4.5%, with a volatility of 3.75%

• A 50% cash / 50% equity split predicts a return of 6% with a volatility of 7.5%

• A 25% cash / 75% equity split predicts a return of 7.5% with a volatility of 11.25%.

You pay a very high price for sleeping more soundly at night. The 7.5% return from the most volatile equity-dominated portfolio might not sound that much more lucrative than the 4.5% you’d get from the 75% cash-dominated one, but turning to our compound interest calculator we see:

• Low volatility, smaller returns: £10,000 a year sunk into the low return cash-dominated portfolio would be worth £638,000 after 30 years.

• High volatility, bigger gains: £10,000 a year invested into the high return equity–dominated portfolio could be worth £1,112,000 after 30 years.

The lesson: For most people, concentrating on reducing volatility to protect their net worth too early will greatly cap their returns.

Volatility is the price we pay for chance of a superior final outcome. But once you’ve made what you would consider enough money, this flips and you’d rather not lose it.

Target acquisition

To see just how hard it is to plan how much money you need, have a play with FireCalc’s returns simulator to see how long your money could last in retirement. It uses US data but the general principle applies in the UK.

Start with too small a nest egg, or experience a bad run of luck with a risky portfolio, and you can be left with nothing to explain to St Peter – but many years in poverty before you have to.

How much is enough? I don’t have an answer – however much I need, I’m not there yet!

True entrepreneurs like Branson or Bannatyne will certainly never be satisfied, but then they’re in it for the money like a scorecard. Nearly everyone else will find money after a certain point does not buy more happiness, and the law of diminishing returns kicks in.

A good aim for most of us mere mortals is to have enough to replace your salary with a diversified investment income – one with a decent proportion of real, inflation-sensitive assets like equities and commercial property in the mix, to keep you going long-term.

Complicating the timing of the shift to wealth preservation, if you can ride out the ongoing volatility there’s a good case for keeping some equity exposure even in your old age, perhaps via income investment trusts or a HYP, to further guard against inflation.

Income tends to be much less volatile than capital ². If it’s too soon to worry about preserving the latter, then concentrating on the former while accepting the capital will fluctuate may be a practical compromise.

Happily wealthy every after

If you continue to work and save after you reach your income target – or if your investments do better than expected, sooner than expected – then you can look to reduce risk a little by allocating still more money to your income fund in total, but directing a greater proportion of it towards safer assets like government bonds.

Think you’re rich enough already? Then switch to preserving your wealth, and work too on simplifying a few of your tastes to have a margin of safety!

1. The second rule is, of course, not to forget rule one.[↩]
2. Interest on cash aside[↩]

Good articles from around the web.

My favourite read this week was a long memo (PDF download) from Oaktree Capital’s Howard Marks to his clients.

Entitled How Quickly They Forget, it’s a recap of the past five years from the coal face of active investing and a snapshot of the present, framed within a reminder that the investor sentiment cycle demands active amnesia from participants in the market.

Marks writes:

The human mind seems to be very good at suppressing unpleasant memories. This is unfortunate, because unpleasant experiences are the source of the most important lessons.

When I was in army basic training, I was sure the memories would remain vivid and provide material for a great book. Two months later they had disappeared. After the fact, we may remember intellectually but not emotionally: that is, the facts but not their impact.

The article is well worth a read for insights into how risk premiums priced into different markets can give a good heads-up on excessive euphoria or bearishness.

High-yield bonds are the big concern for the memo’s author. Equities look fair to fully priced, despite investors being ‘handcuffed volunteers’ forced to buy them by the artificially low yields on offer elsewhere.

From the investing blogs

• What is happening to the High Street? – Simple Living in Suffolk
• The promise of fundamental indexing – Canadian Couch Potato
• How Buffett really applies his margin of safety – Gannon on Investing
• Gold in a bubble? – Retirement Investing Today
• Asset allocation comes first. Then fund selection – Oblivious Investor
• A review of the excellent Free Capital by Guy Thomas – iii blog
• ETFs – worse than he thought – Terry Smith’s blog
• President Obama is an index investor – Bible Money Matters
• Overdoing the UK income gloom? – David Smith
• A red letter day [Endowment mortgages RIP] – A Grain of Salt
• $12 million underwear and other eBay finds – Len Penzo

Mainstream media money

• Faith and [or in] the markets – The Economist
• Is the UK government cooking up a mis-selling scandal – Peston/BBC
• Too Big To Fail [Review of the upcoming crisis film] – MoneyWatch
• 5 differences between passive and index investing – Swedroe/MoneyWatch
• Super podcast with Supertrends author Lars Tvede – Motley Fool
• Only 16 of 1,168 funds in top 25% for three years in a row – FT
• Reducing your energy costs for fun and profit – FT
• Income is out there, but not without risk – FT
• Uncovering high-charging ‘closet trackers’ – The Telegraph
• The ‘ostrich generation’ of pension fantasists – The Telegraph
• Top five equity release myths – The Telegraph
• Are Britain’s happiest families wealthy? – Independent
• Secondary market for VCTs [apparently!] opening up – Independent
• Mobile phones calling in the cashless society – The Guardian

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