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Your Questions Answered by Jim O’Donnell
Posted By Jim On 01/28/2009 @ 7:45 am In Investing | 3 Comments
Last week, we closed the giveaway of five copies of The Shortest Investment Book Ever by James O’Donnell and Professor O’Donnell selected five questions from the thirty submitted queries to answer. For those who may have missed it, I wrote a review of The Shortest Investment Book Ever  a few weeks ago and now five readers have won brand new copies of it for their own libraries!
Professor O’Donnell was very gracious in answer these questions, which range from the technical (modern portfolio theory) to the softer (how money perceptions have changed), and I hope you find value in them.
Question #1: Modder asks: My question: Is modern portfolio theory  (Markowitz – efficient frontier based analysis) useful in today’s environment? The basis for the analyses, such as risk and return data, have to be totally skewed or noisy at this point given the recent volatility – what other approaches would you suggest to someone concerned with asset management short of putting all $$ under the mattress?
For sure, after what we’ve been through – and are still going through – it is tempting to look for answers to our mutual distress in any quarter other than where we have been operating. I doubt that you’ve yet read my book, The Shortest Investment Book Ever , but it does draw its investment principles from Modern Portfolio Theory and from the use of “the efficient frontier.”
So, is it time to throw the whole theory overboard? Maybe.
But I’m not ready to go there. You also, playfully, I’m sure, allude to putting money under a mattress. Others might say that “market timing” might save us. But I don’t think so. At the heart of Modern Portfolio Theory is the wisdom of understanding who I am as an investor in terms of age, risk tolerance, and goals. In light of that kind of intelligent investigation, we should set up a widely diversified portfolio of investments to pursue those goals.
History tells us, too, that diversification works best – not perfectly, perhaps – to dampen the risks associated with investing. Frankly, I’m not aware of what would work better to help us garner the bulk of long-term returns (about 10%) one might get on our long-term investments. To take my own case during the past year, for instance, I lost 30.5% on my overall portfolio — a dreadful outcome, indeed. But my results are considerably better than a pure equity mutual fund that lost, on average, about 40%. So, hang in there with the diversified, long term, low-cost, equity-oriented portfolio for your retirement savings.
Question 2: Thomas asks: I have not read the book, so maybe this is being covered but what do you specifically find attractive or unattractive about target based retirement funds? These are being pushed out to small investors as easy ways to take advantage of low cost funds and adhere to the rebalancing of an account automatically.
“Target-dated” mutual funds, also called “lifecycle funds,” serve a good purpose for those of us who HATE or FEAR investing. After all, under our economic system, in which 62 million Americans save for their own retirements through 401(k and 403(b) plans, target-dated funds can offer a reasonable compromise to doing nothing, doing the wrong thing, or becoming a wreck thinking about what we don’t want to think about. They automatically do the needed, occasional rebalancing, which is a great plus for the “scaredy cat” and the unknowing. Where I think they can still be improved, in some cases, is in their expenses, and, too, in their diversification, which does not take many target-dated funds into enough worthwhile, asset class diversification. Too often, target-dated funds give an investor stocks and bonds only, which will do OK; but I’d prefer to see them include foreign stocks, emerging market equities, and real estate, too.
Question 3: John asks: What is the one piece of info you would repeat, repeat, repeat? Something that people hear about, know about, but always tend to overlook it, or gloss it over as not that important. The past few years of my studying personal finance and planning details for retirement in a few years, I completely overlooked taxes on my pension and IRA withdrawals, as well as on Social Security – now it’s part of my plan, but what a big mistake that would have been…
There is lots and lots of investment advice that bears repeating, but in this climate of fear and loss, I’d want to remind everyone that, while the long-term return from equities is about 10%, that return does not arrive in a consistent, steady return. Rather, investment returns are “lumpy.” What happens is that markets tend to go nowhere for years, and then, without a bell ringing, a siren going off, or an email alert, they go up substantially. And do so for years. Look back over the last century, which includes two world wars, the Great Depression, several recessions, oil embargoes, terrorist attacks, and what we find is about a 10% return from equities. If we look at just the last, say, 30 years, we had returns for close to 20 of them of about 19.85% per year (from 1982-2000). But since then, returns have been negative by a few percentage points a year.
The message I read from all this is simple: When returns have been rich and robust for years, it’s likely that a sharp downward correction is coming. And, on the other hand, when things have seemed dreadful for years on end, it’s not unlikely that investment returns are going to get better.
Question 4: Kim Varner asks: In what ways is today’s market similar and dissimilar from the Great Depression?
There are similarities in that both crises were related to banking crises. Both gave rise to catastrophic losses of confidence and trust, which fed on themselves driving confidence and trust lower and economic activity along with it. But – and this is an important “but” – I don’t think that we are entering another Great Depression. Why? Because I think governments around the world are too active in coordinating huge efforts at intervention. And while I wish there weren’t the need for governmental action, we’re at one of those unfortunate moments in history when I’m grateful that governments are as active in this mess as they are. For most definitely, that was not the case in the Great Depression and why, I believe, the “Great Recession” of the 1930s turned into the Great Depression.
Unlike the coordinated efforts today, back in the 1930s, governments made four very large policy errors that lengthened and deepened that turndown. One and two, they raised interest rates and raised taxes. Three and four, they shrank the money supply and built protective barriers against world trade. At its bottom, the Great Depression saw stock prices fall about 90%, national unemployment rise to 25% (with some cities seeing 75% unemployment), and productive output fell about 25%. I see no repetition today of the same policy errors that made a serious, cyclical recession morph into the Great Depression. But, like the rest of us, nor I don’t have a crystal ball to see the future. While I do not see a repeat of the Great Depression of the 1930s, I see some daunting challenges ahead – maybe a different kind of depression – because of possible future inflationary problems and/or a debased currency.
Question #5: Gopinath asks: My query is: What are the indications that the market has hit the bottom so that we can put in the hard earned money for investing (rather than speculating and losing)?
Markets will ALWAYS hold opportunities for both risk and return, so I’m not sure I can tell you when the “all clear” will be sounded. But here are a few things we all should be looking for to signal the likely return of better times. First, markets turn before economies, so, for example, don’t think that unemployment numbers will get better or even stop getting worse before markets move up.
Next, realize that markets begin to improve or even begin to go up when news gets less awful (not necessarily “good), then less bad, then not so bad, then mildly good. In fact, when bad news flows on a given day, and market does not tank (and we’ve seen some of this in recent weeks, that’s an encouraging sign that a bottom may be near. In other words, for those waiting to hear a constant stream of dramatically good news, by the time that comes, markets will long since have gotten a whole lot better. I’d also say that when a bottom has arrived, volatility will retreat (of course, before it spikes again on the way up). And volatility has come down, too. In Oct., Nov., and Dec. of 2008, market volatility went from being historically horrific to just plain bad. That was an improvement, even if only on a relative basis. But Jan. of ’09 has been just terrible, on the other hand, in its negative returns and in a pick-up in market volatility.
And lastly, while there’s no precise way to measure it, extreme bearishness is a good clue that the market has hit bottom. After all, when all the bears have sold, there’s nothing left but upside opportunity. By definition, the moment of maximum bearish sentiment is coincidentally the moment of greatest upside potential. Again, there aren’t precise measures of bearish sentiment, but in my opinion, right now, I’ve never lived through a time when there has been more predictions of gloom and doom. Hmmm…that may mean we’re actually near a bottom.
Thank you to all the readers who submitted questions, thank you to Professor Jim O’Donnell for taking the time to answer these questions, and congratulations to the winners!
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 Last week, we closed the giveaway of five copies of The Shortest Investment Book Ever by James O’Donnell and Professor O’Donnell selected five questions from the thirty submitted queries to answer. For those who may have missed it, I wrote a review of The Shortest Investment Book Ever: http://www.bargaineering.com/articles/r/amazon.php?asin=0802446523
 modern portfolio theory: http://en.wikipedia.org/wiki/Modern_portfolio_theory
Thank you for reading!