Stocks have been sliding relentlessly since January 20. While we are adjusting our position to over 90 percent cash, we do believe that there is still some near-term growth potential for stocks, especially in certain sectors. Real estate, pharmaceuticals, and large-cap stocks look particularly good.
Monthly Archive for January, 2010
Stocks have been sliding relentlessly since January 20. While we are adjusting our position to be mostly in the money market, we do believe that there is still some near-term potential for stocks coming back. Both the I Fund (“Europe Pacific”) and the S Fund (“Extended Market”) look good.
Though the C Fund (“S&P 500″), which we recommended two weeks ago, has declined, our newsletter is still performing well. During the past year, our Balanced allocation has risen 10.64%, while our Conservative allocation is up 3.05%.
We are holding on to biotech, as we still think it has good longer-term potential. Though many stocks dropped at the end of last week, biotech dropped less than large-cap stocks, indicating strength.
As the year begins, large company stocks are doing great. Bonds, which we recommended last time, are in a good uptrend too, though it is not as good as the one in large stocks.
Despite its sharp drop on Friday, biotech, which we recommended last week, continues to be in a strong uptrend. Another good investment right now is gold. Utilities, while still promising, are relatively weaker, so we are no longer recommending them.
This week, we’re recommending biotech, which has been doing well in the recent past, outperforming the general stock market. Utilities are a good way to diversify the biotech position.
It’s that time of the year again — people are going to be receiving statements from their retirement plans (including the Thrift Savings Plan) showing how much money they have made (or lost) within the past year.
The confusing part is that, even if you had stayed within a particular fund for the entire year, the return shown on the statement will likely be different than the return of the fund. This happens because people add money to their retirement accounts throughout the year. Every time you add money, you buy a little bit more of the fund at the then current price. This is known as dollar cost averaging or DCA.
What’s more, even if two people were in the exact same fund for the whole year, the returns shown on their statements will likely be different from each other. This is because the return depends on several factors, such as:
- the amount of money in the account at the beginning of the year;
- the amount of regular contributions; and
- the timing of the regular contributions.
Since these three factors are likely to be different for different people, the returns they see on their statements will also be different. Because of this, the return is often called the personal rate of return (PRR) or the personal investment performance (PIP).
Below, I discuss two formulas for calculating this personal return. The first formula, which I call the personal rate of return, is relatively easy to use and to interpret, though it is an approximation. The second formula is the one used by the TSP and other retirement plans. The formula is commonly called the modified Dietz method, while the TSP simply calls it the personal investment performance. Though the formula is exact, I think it is more difficult to use and interpret.
Personal rate of return. The personal rate of return (PRR) is calculated as the weighted average of two other returns, the lump sum total return (LSTR) and the dollar cost averaging total return (DCATR). These are explained below.
Let
- MB be the money in the account at the beginning of the year; and
- let MC be the total amount of money contributed throughout the year (that is, it’s the amount contributed per pay period multiplied by the number of pay periods).
Then,
PRR = (MB x LSTR + MC x DCATR) / (MB + MC) – 1
For example, suppose that,
- at the beginning of the year, you had $50,000 in your retirement account;
- you contributed $500 per pay periods for 26 pay periods (1 pay period every two weeks);
- the lump sum total return (discussed below) was 1.2; and
- the dollar cost averaging total return (discussed below) was 1.1.
Then, the calculation is as follows:
- MB = $50,000
- MC = $500 x 26 = $13,000
- PRR = ($50,000 x 1.2 + $13,000 x 1.1) / ($50,000 + $13,000) – 1 = 17.94%
Now, let’s discuss LSTR and DCATR.
Lump sum total return. “Total return” means 1 plus the return. For example, a return of 20% corresponds to a total return of 1.20. “Lump sum” means the total return on the money that you had in your account at the beginning of the year. For a fund, LSTR is equal to the price on the last day of the year divided by the price on the last day of the previous year.
Dollar cost averaging total return. This is the total return on the money contributed throughout the year. The formula is similar to that for LSTR. It is the price on the last day of the year divided by the effective purchase price. The effective purchase price is the harmonic mean of all the fund prices throughout the year. For details, see a more thorough explanation with graphs and examples.
Personal investment performance. We now come to the formula used by the TSP, called either the modified Dietz method or the personal investment performance (PIP).
Let
- EMV be the market value of your account at the end of the year;
- BMV be the market value at the beginning of the year (this is the same as MB above);
- CF be the total cash flow or contribution into the account (this is the same as MC above);
- i be the index on specific contributions to the account;
- CFi be the amount of the i-th contribution (in other words, CF = sum CFi); and
- Wi be the number of calendar days from the i-th contribution until the end of the year divided by the number of calendar days in the year.
Then,
PIP = (EMV – BMV – CF) / (BMV + sum (Wi x CFi) )
… And that’s how the personal returns are calculated and why they are different for each person. 
I regularly receive emails from people who tell me that they have been following some investment methodology, such as buy and hold, have recently lost a lot of money, have found our newsletters, want to follow our newsletter, but are afraid. (Boy, was that a mouthful. )
They are afraid that by switching out of their losing investments, they will “lock in” their losses. They feel that, while they have lost money, those are “paper losses”. But once they switch out of the losing funds and start following our newsletters, they will somehow make those losses more real.
I think that many people get confused for the following reason. They see a fund that has lost a large amount of money fairly quickly, so they reason that it should regain that money just as quickly. They are afraid to get out of the fund because they are afraid to miss this big up move.
The reality is that a big loss in the recent past does not imply a big gain in the near future. The false belief that this implication exists is an example of a cognitive bias called the gambler’s fallacy. Someone who commits gambler’s fallacy thinks that returns are negatively autocorrelated, that is, that negative returns are typically followed by positive returns. However, returns are not autocorrelated, either negatively or positively.
This incorrect belief is why people are afraid of “locking in” their losses. They are afraid to miss the big up move which, they believe, is imminent. However, there is simply no evidence that returns behave in this way.
Question: Although hundreds of billions are going into bond funds at this time, that seems imprudent to me. Why? Historically low Fed Rates are bound to be raised. Even anticipation of rising rates results in falling bond prices; actual rate rises will probably cause even higher rate of bond price drops. In light of the impending bond bubble burst, is it prudent to hold the high percentage of TSP assets in F Fund (“Total Bond”) that your January newsletter recommends for Conservative Allocation? I’d rather be early in eliminating or significantly reducing my TSP portfolio’s risk that investing in bonds entails.
Response: This is a great question. You and I seem to have different approaches to investing. You are attempting to predict or anticipate what will happen. I am simply trading based on what is actually happening right now. You are saying that rates are bound to be raised and so bond prices are bound to fall. I am saying that bond prices are going up right now, and so that’s why I am in bonds.
The issue with my approach is that things can change — they do not have to stay the way they are. My defense against this is that I update my calculations twice a month, and in doing so, hope to catch things before they change too much.
The issue with your approach is that your predictions might not come true. Since your trades are based on your predictions, if your predictions do not come true, that calls the trades themselves into question.
We’re recommending a mix of funds this week. Of the funds that we’re recommending, the telecom fund has the highest expected return. But because of its relatively high risk, we’re recommending the other funds as well, to moderate our overall risk exposure.