2 and 20 rule

Nov. 10, 2009 1:15 PM ET
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Ted Stamas's Blog
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Long Only, Value, Growth At A Reasonable Price

Contributor Since 2008

I am in the John Bogle camp of primarily being in low cost, diversified index funds, particularly the S&P 500. Allocate 10% of my portfolio to individual securities. Contribute sporadically and infrequently. Also trade infrequently. Degree in business administration from Ithaca College in Ithaca, New York. Been investing over 30 years, and writing in various formats for 35 years.

The 2 and 20 rule is the standard fee arrangement at most private equity funds. Hedge fund managers typically get 2% of the assets they place at risk for you and 20% of any profits, hence 2 and 20, a scam if there ever was one. Although this is a fairly well known axiom throughout investing circles, I was originally made aware of it by reading Barton Biggs' Hedgehogging which is an insider's account of the hedge fund industry. The book states that besides the astronomically high management fees, private equity funds don't beat the S&P 500 index the majority of the time. If you are interested in reading a good investing book, especially about hedge funds, Hedgehogging is highly recommended. It should be noted that here at The Ithaca Experiment, the only fees incurred are taxes and broker's commissions. After all, this is do-it-yourself investing.

As I crawl from the wreckage of a miserable week for my portfolio, I think back to Benjamin Graham who is the father of Value Investing and his allegory of Mister Market. To Graham, Mister Market is a manic depressive who comes to the stock market each day with shares to trade. Some days he is an especially upbeat mood and will offer shares at extremely high prices and other days he is depressed and will low ball his offerings. Right now Mister Market is in an elevated state and there is no way, shape or form the indexes should be so high based on the P/E ratio of the S&P 500. I understand there is a lot of bullish market sentiment and in the short term, I am losing money, but I am not going to chase performance.

Graham is also famous for saying in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine. What he means is that after a duration of time it is the earnings of a stock or index that matter most. The current P/E Ratio for the S&P 500 is 20, very high by historical averages, and the growth rate is projected to be 35% for next year according the the Standard and Poor's Web site. With an unemployment rate of over 10% and growing, I do not believe the S&P 500 earnings will increase at a rate of 35% next year no matter how much cost cutting the companies have done.

The market could rally 5 to 10% by year's end because November and December tend to be the two best performance months for the stock market, but I've taken my stand and so did General Custer at the Little Big Horn. If I were to sell my short positions now and go long for say a month or two, I'd be defeating the purpose of holding my shares for more the 365 days for long term capital gains and losses. Sure, there is a certain amount of anxiety involved when you are going against the popular momentum, but I am willing to take my chances.

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