I read recently that Warren Buffett’s Berkshire Hathaway second quarter profit fell 40% as some bets he made on stock market futures didn’t pay off. He also sold shares in ConocoPhillips in the second quarter because he said he made a mistake in buying them in 2008 when oil shares peaked.

So if the “Wizard of Omaha”, the man whom the media (and many investors) fawn over, makes mistakes picking short-term market directions and individual stocks, what chance do you and I have to make the right guess with our investments? Seems to me the chances are really low.  So why bother?  You’ll have more investment success creating a well-diversified portfolio of stock and bond indexes and sticking with them rather than trying to be your own “Wizard of Anywhere”.

Sam Mamudi penned a very insightful and thoughtful article for MarketWatch that points out the huge role that luck plays in investment success. I highly recommend the article because it presents several important ideas that every investor needs to know:

There is randomness in investment returns and no one can anticipate what will happen next with investment markets with any regularity; the article has some amazing statistics about the value of a portfolio after various 30 year periods (about how long most of have to save for retirement).

We tend to over-estimate our own investment skill — when something bad happens to our portfolio, we blame it on “the markets” or the banks or the Chinese; when something good happens with our investments, we think we’re a genius.

Therefore, an investor needs to worry about the things we can control: how much we save, how early we start saving, our portfolio diversification, choosing low cost index funds as our securities.

We are our own worst enemy when it comes to our health and our investments. Even though we know we’re supposed to rebalance our portfolio regularly, we don’t; even though we know we should save automatically, we don’t.

Check out the full article and see what insights you gain into your investment behaviors. Good article worth reading.

A client recently sent me a summary of research done by Fidelity Investments that showed the best performing asset class by decade (thanks David R.). Using average annual return from 1930 through 2009, here are the best asset classes:

1930’s                     Investment grade bonds                   5.4%

1940’s                     U.S. small cap stocks                    20.7%

1950’s                     U.S. large cap stocks                     19.4%

1960’s                      U.S. small cap stocks                   15.5%

1970’s                     Commodities                                   21.3%

1980’s                     Non-U.S. stocks (developed)             22.8%

1990’s                    U.S. large cap stocks                       18.2%

2000’s                   Emerging market debt                        10.9%

Fidelity makes several observations about these data. First, not all asset classes were available in all decades. For example, commodities and non-U.S. stocks in developed countries were not available to retail investors until the 1970’s. Second, the number of new asset classes becoming available to investors is increasing. For example, emerging market debt and Treasury Inflation Protected Securities (TIPS) came on to the scene in the last decade.

What this means is that an investor has greater opportunities for diversification — a cornerstone of most investment portfolios — than ever before. This gives the individual investor the option to complement traditional asset classes with non-correlated asset classes to potentially achieve better returns with less short term risk.

Let me know if you’d like a copy of the article from Fidelity by dropping me an email at steve@finpath.com.

I’m an un-abashed Vanguard fan when it comes to most things investment oriented. It is not a perfect company, but darn good and their intellectual honesty and process is top notch. So when Vanguard publishes a report titled “Vanguard’s economic and capital markets outlook” I read it.

This annual publication came out recently and here are some highlights:

1. Their experts estimate the probability of a “double-dip” recession at approximately 10%.
2. Vanguard expects global expansion over the next 10 years to occur at varying levels; for example, they see the economies of the emerging markets and Australia expanding the fastest, the U.S. growing more modestly and Europe, England and Japan showing sluggish growth. Caution: before you rush out to buy the sector funds that focus on emerging markets or Australia, this widely expected global growth prediction has already been priced into securities. Remember: markets are efficient, meaning most information is available to everyone else too.
3. Vanguard expects inflation to trend at about 3% over the next ten years, somewhat higher than the current 1% to 2% we’ve experienced over the last few years. Average annual inflation of 3% is normal over the last 100 or so years in the U.S.
4. The Vanguard gnomes expect long-term U.S. interest rates from bonds to be in the normal 4.5% to 5.5% (they’re about 3% today) with a normal yield curve.
5. And here’s a juicy factoid, the Vanguard experts see the long-term median return for global equity markets to be near historical averages of 8% to 12%.  And according to Vanguard, “the expected return differential between U.S. and non-U.S. equity portfolios is statistically insignificant.”

The Vanguard reports includes forecasts for individual asset classes as well.

Vanguard states (and I agree!) that “…investors should consider market forecasts only in a probabilistic framework.” Meaning they are forecasting return distributions not short-term “point forecasts.”

If you’d like a copy of the full report, please drop me an email and I’ll send you a PDF of the report. I don’t think Vanguard will mind since I’m not trying to sell the report.

Met Life recently issued a retirement readiness report for Americans. The findings largely mirror the results from similar studies done by other groups, but the major findings are still worth noting.

The Met Life study measured retirement readiness in 5 areas:

• Income and benefits
• Work
• Leisure
• Relationships
• Overall planning for retirement

Here are some of the reports conclusions:

1. About half of Americans are still planning to retire at the same time as when they were planning to retire a few years ago; the other half  say they plan to work longer.
2. Among existing retirees, 64% say they retired earlier than planned, 33% retired when they expected and only 3% said they retired later than planned. Observation: start planning for retirement earlier than you want.
3. About 50% of American say they feel prepared to retire, 20% say they’re not ready. Among those who say they’re ready to retire, the task that stands out is those are the people who have set clear goals and looked at whether their plans have considered personal, social and financial changes.
4. Speaking of finances, half of Americans say they’re behind on their retirement savings with 25% saying they’re significantly behind. Observation: the housing and investment market busts that we’re still recovering from have hit people hard financially and emotionally.

Summary: Retirement is not an event, it lasts for a lifetime and it’s not something you start planning for a couple of years before you want to retire. The most successful retirements occur because a person or couple started planning early and looked at all the aspects of retirement — not just the money side of it.

A client emailed me the other day and mentioned how crazy the investment markets seem to be these days. I agreed with her in an email response and her comment got me to thinking about the nature of investment markets and why they seem to be crazy. Here is my conclusuion.

#1. Markets are efficient. Due to regulatory oversight,  markets are efficient when it comes to information.  That is,  most of the information about a security (the stock of a company, for example) is available to all individuals all the time. That’s what meant when the academics say a market is “efficient.” The SEC has very strict rules to make sure investment markets remain efficient in this sense too. You’ve heard of insider trading violations? That’s what happens when someone on the inside trys to take advantage of information that is not publicly available to make a profit.  Markets are not perfectly efficient either. Just very efficient.

#2. Markets are irrational. It’s people who are making investment decisions all the time. Individuals make guesses about the future and then decide to buy and sell. And when people are making guesses about the future, markets are irrational. For example, when the Greek government announces to the public (remember that markets are efficient users of information) that they are instituting harsh economic measures to cut their government spending, people in the investment markets all wonder “what does this mean for the future?” and make decisions based on their guess about the future. By its nature, guessing about the future may be more logical or more emotional.  But it’s always a guess and sometimes our guesses about the future are crazy.

These two observations lead me to once again suggest that the best way to invest is to index across different asset classes because if markets are irrational (and they are), there is no way to guess which way they’re going to go.  Diversified index investing covers all your bases for your time horizon and gives you the confidence to know that no matter what information comes out and no matter what guesses the experts make about the future as a result of the new information, you’re investments will be fine.

Does that make sense to you?

The Chicago Fed publishes a nifty monthly index that is a snapshot of national economic activity. It’s called the CFNAI and for May the index moved slightly lower compared to April. Industrial and manufacturing production moved higher, but employment, consumption and housing were lower.  The three-month trend is still positive and above its historical trend, yet there are many dark economic clouds swirling around in the U.S. and abroad.

What does this mean to you and me? My take is that we are still in the midst of a long, slow climb out of the Great Recession and it’s likely to go on longer than most of us realize. Bill Gross, the bond guru from PIMCO, was quoted recently as saying he believes we’re facing investment returns in the 5% range for the next 10 years.

If that’s the case, then you may need to revisit your long range saving assumptions and adjust accordingly. For example, if your projection for college savings assumed 7% college cost inflation and 10% earnings, you may need to save more or expect junior to pay more for his own college costs. Similarly, if your retirement income goals require you to earn 8% on your pre-retirement investments, you may need to save more, work longer, live on less in retirement or some combination of these.

In sum, now at the mid-year point is a good time to review your financial planning assumptions and adjust if necessary. Financial planning is not a one-time effort; rather, it requires regular monitoring and making adjustments if long term trends require it.

Since it’s summer and many teenagers are finding summer jobs, here is a plug for Mom and Dad (or grandparents) to put money aside for the working teenager into a Roth IRA for them. As long as the teenager is gainfully employed, she/he can contribute up to $4,000 into a Roth IRA. Of course, the value of the Roth IRA is that it accumulates tax-free.

If the working teenager puts $4,000 a year into a Roth IRA between the ages of 16 and 21 (six years total) AND THEN DOES NOT MAKE ANY OTHER CONTRIBUTIONS,  the value of the account will be worth over $1,000,000 when she/he is age 65 (assumes 8.5% earnings).

If you worry about the future for your teenager(s), start a Roth IRA for them. It will make you sleep better at night. I guarantee it.

The investment results of the Yale University Endowment Fund have been very good over the last 10 years, especially when you compare it to what else was happening in the investment world during these 10 years.

This private fund returned 11.81% on average each year between 2000 and 2010. For comparison, the Vanguard S&P 500 Index averaged -2.29% per year over that same time. When people read about the Yale Endowment Fund, many will say “I’ll have some of what they’re having.” (Note: do you know the movie from which this line is taken? Hint: Rob Reiner’s mother said it.)

While the Yale Fund averages 11.81% a year return, it’s not without its ups and downs either. In 2002, it returned .70%, in 2008 it earned a 4.50% return and in 2009, it lost 24.60%.

This fund has such positive results largely through its diversified holdings, many of which are not available to the public. For example, the Yale Fund usually maintains a 15% to 25% allocation to U.S. and non-U.S. private equity in its portfolio.

But before you despair that you can’t have what the Yale Fund is having, it turns out that you too can achieve good returns with readily available ETFs. Craig L. Israelsen, a professor at BYU and a principal of Target Date Analytics, shows us how.

In a March 2010 article in Financial Planning magazine, Mr. Israelsen reported that a multi-asset portfolio made up of 12 retail ETFs returned 6.29% on average between 2000 and 2010. This isn’t a “knock your socks off” return like the 11.81% average annual return of the Yale Endowment Fund, but it’s not chopped liver either. If you had invested $10,000 in the diversified ETF portfolio in 2000, it would have been worth $18,412 at the end of 2009. Investing $10,000 in the Vanguard S&P 500 Index over the same time would have left you with $7,930.

Mr. Israelsen writes: “Both the Yale Endowment Fund and multi-asset portfolio view alternative assets as critically important components of a well-diversified portfolio. Why? Because including nontraditional assets enhances performance and reduces risk.”

He goes on to write, “So while alternative investments usually zig when traditional equities zag, a portfolio can be vulnerable when they zag together. Fortunately, we haven’t seen that very often.”

If you would like to read the full article, send me an email and I’ll share it with you.

Dear KJ

Today  is Father’s Day and I wanted to share my thoughts with you as a Father about your personal finances. I know right now a big financial decision for you is how to spend your meager allowance and how to make your birthday money go as far as possible. One day you’ll be making more complicated money decisions. That’s what seems to happen as you get older – the money decisions are more complicated. So here are my top 8 money tips to you.

1. Have life goals and make smart money decisions to help you reach them. Another financial person I know said, “Your money is an extension of you and you get to use it as you want. Use your money with purpose; don’t let it just evaporate into the unknown.”

2. Know the difference between “needs” and “wants.” We’ve talked a little about this already and please don’t forget it as you get older. A “need” is food, shelter and clothing. Almost everything else is a “want” and can be delayed.

3. Save early and often. Your Mom and I have started you on this path already by asking you to save 10% of your allowance and birthday money. Keep doing this and when you need cash some day for one of your life goals, it will be there.

4. Know how much you spend every month. Right now, you spend money on video games, movies, special school supplies and other fun stuff. Later in life you’ll spend money on gas, food and clothes. As I suggested in #1 above, no matter how much or how little you spend, use your money with purpose.

5. Invest wisely. You’ll hear about the miracle of compound interest one day soon and it’s the single most important investment idea I can share with you. Each dollar you save earns some interest and then that bigger amount earns more interest without you having to do anything. This is the reason we have you put your savings into the local bank where it can earn interest instead of keeping in your piggy bank. Combine this idea with #3 (save early and often) and you’re on your way to being a true financial genius.

6. Borrow rarely. Soon, very soon, you’ll be tempted to get a credit card. The promise of a credit card seems too good to be true. Buy something now and pay for it later. But as you know even at your age, if something seems too good to be true, it probably is.

7. Be prepared. Remember when our family dog died after a long and wonderful life? We were all sad and your Mom and I tried to help you understand that stuff happens in life and we need to be prepared. The same rule applies when it comes to your financial stuff. When you own a car, house or have a job, you never know if something unexpected will happen so be prepared for it.

8. Be generous. You are blessed to grow up with two parents who love you, you have a roof over your head and enough food to eat and warm clothes to wear. Not everyone is as lucky as you so be generous with others. Give away some of what you have to others who need it more and you’ll make the world a better place and you’ll feel better too.

So KJ, this my Father’s Day gift to you. I hope this helps you as you pick you way along your life’s path. I hope you’re fortunate enough to be a father some day too. Thanks for being a great son.

Love,

Dad