Strategies for the successful investor part 5 :Do not trust experts or fund managers

The one thing that most people think is that they can outsmart the market and have a better return than the overall return of the market. What can happen is that a few person can outperform the market for a few years but over the long run they would most likely either underperform the market or come close to it.

On the long run the best you can do is to equate the average return of the market. Thus the only investment that would come close to the market average rerun would be the index fund or a mutual fund that is invested in a broad range of stocks and bonds.

why is it that no one can outperform the market?

1. Most fund make use of researches and fund managers that are highly paid so that their salaries have to be deducted from the return of the fund. This would thus reduce the fund’s overall return.

2. A lot of these actively managed funds rely on selling and buying of shares so that investors in these funds need to pay capital gains tax. These taxes thus reduce the return of the funds.

3. Actively managed funds rely on timing the market. That is selling high and buy low. This is quite difficult to achieve and and as a result the return is less that anticipated.

Hence the index fund or the passively managed mutual fund is the best bet to achieve a return that is as close to possible to the average return of the market. The fees of these funds are low because the funds do not need to pay a lot of researches and fund managers. They also mostly rely on the buy and hold strategy thus reducing the need to try to time the market.

Although funds that try to actively time the market and employs famous fund managers are quite attractive, history tell us that they always underperform the market so keep away from them.

Strategies of the successful investor part 4: Rebalancing

One of the most important aspect of your investing life is rebalancing. As you know a portfolio must be diversified in that the portfolio is composed of a wide variety of asset types such as bonds, stocks, etc. Depending on your investment plan and your risk tolerance the different asset classes will be a certain percentage of the portfolio. And in each asset class their would also be some diversification.

You would probably have stocks that are in different sectors of the economy or bonds that are from different types of issuers such as corporate bonds, municipal bonds or government bonds.

Hence it is important that your portfolio composition be as close as possible to that that your plan states. However the economy is not static. Depending on the state of the economy some stocks might increase in value while others decrease in value. This will cause your exposure to these sectors to change. The percentage of the stocks of some sectors of the economy will increase or decrease in your portfolio.

The change in price might also change your exposure to some asset classes. A bull market might increase the percentage of stocks in your portfolio while reducing the percentage of bonds in your portfolio. If left unchecked the asset allocation of your portfolio will change with time and also the riskiness of your portfolio will change. This might thus reduce your chance of reaching your goals.

Thus you need to rebalance regularly. At least once a year is sufficient. Your aim is to reduce your exposure to certain asset classes that have increased in value while increasing your exposure to those that has decreased in value. You will thus return your asset allocation to that that is stated in your investment plan.

You will thus have to sell securities and buy others. This is the most difficult part for some investors because of the cost involved in selling and buying securities. Also some investors may not like selling performing stocks and buying poor performing stocks. However history tells us that a portfolio left to fluctuate with the market always perform poorly.

So keep rebalancing and your portfolio and you will be on course to riches.  

What are treasury inflation protected securities(or tips)?

Treasury Inflation-Protected Securities (or TIPS) are bonds that are issued by governments. The advantage that you get with this security is that the principal of the bond is adjusted yearly with inflation.Thus the principal increases every year and its real value will remain the same. This is contrary to other bonds whose nominal value remain constant whereas their real value decreases.

Since the principal is adjusted yearly with inflation, its value will increase and as a result the coupon payment will increase. This bond is thus a good investment in times of high inflation. The value of your investment will keep its real value with time. This compares to the normal bonds whose principal and the coupon remain the same thus losing its real value with time.

However in case of deflation like in Japan, where inflation turns negative, the value of the principal and coupon decrease with time. In this case a normal bond would have maintain its nominal value but would have its real value increasing.

So investing in tips is just about deciding whether the future will bring deflation or inflation.

What are treasury notes?

Treasury notes are securities that are issued by governments in order to raise funds to finance deficits. It has a maturity that ranges from 2 to 10 years. Hence it is a security that is traded in the capital market. the capital market is the market in which securities that has a maturity of more than 2 years are traded. treasury bonds is also a security that is traded in the capital market.

The treasury notes are issued at a discount and at maturity the face value is paid to the holder of the notes. The holder of the notes is also entitles to a coupon which is like an an interest paid on a certificate of deposit. This coupon is paid according to a coupon rate which  is merely the percentage of the face value of the note that would be paid as the coupon.

The 10 year note is often used to have an indication of future inflationary expectation. It is often used in the bond spread which is the difference in yield between the 10 year note and the three month treasury bill. The three month maturity date is considered to be so close in the future that the inflation in three month will be close to the actual inflation. The 10 year maturity date however is sufficiently far in the future that the inflation at that time cannot be known. However investors will want to ensure that the yield on the ten year note is adjusted for inflation. Hence the difference between two will be the expected inflation in ten years. The difference in the two yield cannot include a  risk premium like the corporate or municipal bond yield because government treasuries are considered to be the safest of securities.

What are treasury bonds ?

A treasury bond is a government security that has a maturity that ranges from 10 years to 30 years. It is thus a security that is traded in the capital market.

Like the treasury note it is issued at a discount. It also pays a coupon every six months according to a coupon rate. This security is mostly held by institutions that have long term liabilities like pension funds, long term insurers, etc. 

What is a capital market?

The capital market is a market where securities that  that has a long-term maturity are traded. These include treasury notes, treasury bonds, normal and preferential stocks. Generally securities with a maturity of greater than 1 years are traded in it. As you can see all securities that are not traded in the money market are traded in the capital market. The name capital market also indicate that companies and government raise  capital in this market.

The capital market is divided into two different markets. Firstly the stock market also known as the equity market where normal and preferential stocks are traded. Secondly the bond  market also known as the debt market where notes and bonds are traded.

Hence we can see that when companies and government need short term financing they raise funds in the money market whereas if they want to raise fund over the long term they would do so in the capital market.

Government securities: Bills, notes and bonds

Government securities are debt instruments that are issued by central banks with the aim of raising funds to finance government deficits. They can also be issued as a result of monetary policy where they are used to drain liquid. Although government usually prefer to use longer maturity to finance deficits while central banks usually like short-term maturity securities in monetary policy.

Types of government securities

There are four main types of securities that government issues

1. Treasury bills 

2. Treasury notes

3. Treasury bonds

4. Treasury inflation protected securities (Tips)

These securities given the fact that they are issued by the government they are considered to be quite safe. However you should be aware that not all government securities are safe. Investors should remember examples such as Argentina defaulting on its bonds or Dubai trying to dodge  out of its obligations by asserting that legally the bonds are not issued by the government but by a separate entity control by the government.  

These government securities are also highly liquid. In fact government securities are  the most traded of all securities. This is because by law banks, insurers and other financial institutions are required to hold a certain percentage of safe assets on their balance sheets. Hence a lot of these institutions hold government securities to reduce risk in their portfolio.

The increased liquidity comes from the fact that these institutions needs to have access to their funds at short notice. However when they do not need their money they need to invest it in a safe asset that they can sell easily. Hence this add to the increased liquidity of the government securities.

These securities can be obtained from two ways. Either over the counter at central banks and with financial institutions or though a system of auction at which financial institutions bid for them. we have already seen this system in the post on treasury bills.