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Michael Bodman
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Michael D. Bodman, M.B.A. Portfolio Economics | Actionable Investment Research I am the principal of Portfolio Economics, an economic research and financial publishing company. Unlike Wall Street sell-side analysts, I present information in plain English, so that you can make better decisions.... More
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    "If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks." - John Bogle, Founder of the Vanguard Group

    Apr 08 4:37 PM | Link | Comment!
  • Why Index Funds Outperform

    Instead of trying to beat the market, index funds attempt to be the market. Index funds track household names, such as the Dow Jones Industrial Index and the S&P 500 Index. Creating and operating a passively managed index fund is far less expensive than a traditional, actively managed fund run by a highly compensated fund manager. Index funds don't have active fund managers.

    The index fund movement

    Vanguard pioneered the index fund movement, starting in the 1970s. Today, Vanguard is one of the largest investment companies in the world with approximately $3 trillion in assets. The average Vanguard index fund costs 0.18% a year in expenses, compared to the industry average of 1.02%, according to Vanguard and Lipper. That's 82% lower than the industry average. Every penny you pay in expenses comes directly out of your investment account and into your fund company's account.

    Index funds have not only a cost advantage but also a performance edge. Few actively managed funds consistently beat the indexes they use as performance benchmarks. In a recent article based on a study by S&P, it was reported that none of the 2,862 actively managed funds studied over a six-year period were on track to outperform the market, after expenses, according to The New York Times.

    The amount of skill needed to outperform the market, after expenses, is so great that few, if any, fund managers can do it on a consistent basis. One of the exceptions is Warren Buffett of Berkshire Hathaway (NYSE:BRK.B).

    Takeaway

    Most investors are better off trying to be the market instead of beat the market. Your odds of success are improved by assembling a portfolio of low-cost index funds that are appropriate to your situation and objectives. If you'd like to add an actively managed component to your portfolio, consider adding shares of Berkshire Hathaway.

    Disclosure: This post was originally published by Portfolio Economics.

    Mar 20 1:39 PM | Link | Comment!
  • Why Gold Should Be In Your Portfolio

    The SPDR Gold Trust ETF (NYSEARCA:GLD) has trounced the stock market over the past 10 years. Recently, however, the price of gold has fallen and the stock market has recovered. This relative performance is consistent with economic theory, which holds that adding gold could help diversify portfolio risk.

    Physical gold is heavy and prone to theft. Today, you can own gold without the difficulties of storing and protecting the metal. The SPDR Gold Trust ETF, or GLD, makes it possible to own fractional-ownership shares of physical gold bullion stored in a secure, underground vault in the city of London.

    Gold: The antidote to severe market uncertainty

    Gold is an entirely different asset class than stocks. Unlike the stock market, gold loves uncertainty. Bad news is good news; the worse things get, the better it is for gold. In other words, the metal is most precious in times of grave economic and political uncertainty. Recent history supports this thesis.

    The last 10 years have been like a return to the 1970s, when everything went bad economically. Gold shot upwards in the 1970s, and New York City was on the brink of bankruptcy.

    During the period between 2004 and today, we have been through two foreign wars and the Great Recession. The federal budget has gone from surplus to deficit. Gridlock in Washington has become so bad that the United States nearly defaulted on its debt obligations. The Pentagon has furloughed workers and cut defense projects.

    Against this dysfunctional economic and policy background, gold has flourished as a safe-haven asset, until recently. The economy is just starting to recover, and the stock market is reaching new, record highs. Gold is no longer soaring and could fall significantly going forward.

    The following graph shows the relative performance of the two assets since late 2004, as measured by GLD and the SPDR S&P 500 Trust ETF (NYSEARCA:SPY):

    GLD Chart

    Source: YCharts. Great Recession is shaded.

    As you can see, when the Great Recession hit around 2008, the price of GLD took off. About four years later, as the economic recovery started to gain traction, the stock market, or SPY, went up and GLD started to decline.

    The economic recovery has been far from robust, which could help explain why the stock market has not outperformed gold during the entire 10-year period. Times are still uncertain, and gold remains popular in these circumstances.

    GLD: As good as gold

    GLD is the largest, safest, and most liquid gold ETF in the marketplace. The market capitalization of GLD is $31 billion, which is more than four times greater than its nearest competitor: the iShares Gold Trust ETF (NYSEARCA:IAU).

    GLD's expense ratio is slightly higher than IAU at 0.40% and 0.25%, respectively. Cost conscious investors who plan to hold a gold ETF indefinitely may prefer IAU's lower expense ratio.

    But GLD is the largest and thus most liquid gold ETF in the world. This provides an added measure of safety to GLD holders, especially if you want to cash out your gold holdings quickly.

    GLD holders do not face the risk of owning individual gold mining stocks. Moreover, unlike the performance of gold mining companies, GLD tracks the price of physical gold almost perfectly since late 2004, as shown in the following graph:

    GLD Chart

    Source: YCharts.

    Conspiracy theorists rail against the fact that GLD prevents owners from getting their hands on actual gold bars. It is true that GLD holders can't physically touch any gold bars. In fact, that is the very reason why GLD is the best way to own the precious metal. GLD solves the problem of storing and protecting gold in your home, while ensuring that your investment is "as good as gold."

    The gold is stored in a bank vault underneath London, and the bars are independently audited to ensure that the metal exists. GLD owners receive a fractional interest in the gold bars, similar to owning shares of a public company traded on a stock exchange.

    Portfolio risk analysis

    Gold moves in different directions than stocks and thus provides portfolio diversification benefits. This hypothesis can be tested using statistics. Correlation is a statistic that measures the extent to which two assets move in the same direction.

    1.00 means that two assets move in lockstep, while -1.00 means that the assets move in opposite directions; the closer an asset pair is to 0.00 or negative, the better in terms of portfolio risk benefits. It is increasingly rare to find asset pairs with low correlation.

    The following chart shows the correlation between gold, as measured by GLD, and the stock market, as measured by SPY, since late 2004:

    As predicted, GLD has a very low correlation statistic when paired with the stock market: only 0.25. This confirms that GLD is a separate asset class with significant risk diversification benefits. Combining different asset classes helps to limit overall portfolio risk.

    The bottom line

    Holding part of your portfolio in gold could enhance your risk-adjusted returns: returns per unit of risk taken. The tricky part is managing your emotions because when the stock portion of your portfolio is up, gold will likely be down.

    Rather than selling when gold is down, look at things from the perspective of your total portfolio. If your individual assets are moving in different directions, that's good -- it means you've got risk diversification working in your favor. In the future, when stocks are down, you'll be glad to see the gold portion of your portfolio going up and limiting your overall risk.

    Disclosure: This post was originally published by Portfolio Economics.

    Feb 03 11:01 AM | Link | Comment!
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