What about the content? Is it any good for the $4.97 I paid, or, (if you are not lucky to get the bargain) the $19.95 jacket price? According to the author Daniel Solin, this is the smartest book you’ll ever read because “it is simple. It is understandable”. And simple is good.

Between Chapter 1 and 35, the author talks about the follies of active (or what he calls “hyperactive”) investing as opposed to passive investing, where you buy and hold a diversified mix of index funds that track the entire financial market. There are interesting nuggets of facts and wisdom here and there. For example, between 1985 and 2004, the average annual return of all actively managed funds was a mere 3.7%, whereas the S&P 500 Index returned a whopping 13.2%.

None of this is new to an experienced investor, who is already well versed in the differences between index investing and stock picking. But this is where the story-telling skill of the author becomes important, because no matter how obvious the bottom line is, sometimes we all need hammering the point home (particularly when violent market swings cause even the most seasoned investor to make stupid mistakes).

The book gets interesting from Chapter 36, where the author starts talking specifics, beginning with his 4-step advice: 1) decide on asset allocation (proportion of stock and bond funds in your portfolio) based on your risk tolerance, 2) open account with one or more prominent fund families (Vanguard, Fidelity, T. Rowe Price) to set the ball rolling, 3) choose specific stock and bond funds offered by these fund families to build your portfolio, and 4) rebalance twice a year to reset the proportion back to the original asset allocation.

In short, the author does the following:

1. First, he presents four different asset allocation types, with increasing degrees of risk (and return): low risk, medium-low risk, medium-high risk, and high risk. Your choice of asset allocation depends on your risk tolerance (that in turn depends on your age and other circumstances).
2. Next, he builds the portfolio for each asset type using three kinds of index funds – total US stock index fund (that tracks the broad US stock market), international stock index fund (tracks major international market indexes), and total US bond index fund (tracks broad US bond market) – drawn from each of the three fund families.
3. He wraps up by suggesting you rebalance your portfolio twice a year (opinions vary on this – I rebalance once a year), to reset your portfolio composition back to the original asset mix.

These specific advices will hand-hold a first-time investor through the process of setting up a well diversified portfolio that is guaranteed to achieve at least the market return. And, “over the long term, simply achieving market returns will beat 95% of all professionally managed investment portfolios”. To a newbie investor, this alone should be worth paying $19.95 for this book. If you are a pro, search the bargain shelves of your favorite book store – you may get lucky too.

I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard. Unless I bought during a strong bull market, I would feel confident that I would outperform…and I could just go back and get on with my work.

Coming from the most famous “stock picker” in the world, such drumrolling for index investing may come as a surprise to some. But as I said in this post, he has been advising this for many years, because with index funds you “would feel confident that (you) would outperform” and “get on with (your) work”.

An estimated 30,000+ strong crowd assembled in this meeting to hear from the Sage of Omaha in these troubling financial times. His main message was that it is impractical to expect an earning of 7 to 10% with publicly traded stocks today. Contrast that with past returns: between 1985 and 2004 a simple portfolio of S&P 500 Index fund would have earned 13.2%!.

You can read the meeting excerpt here and here.

EMT or FA – which one is “correct”?

Interestingly, even though Buffett began his session with the Wharton students by criticizing the “misguided” EMT, he later advised average “non-professional” investors to buy-and-hold index funds (the strategy based on EMT), instead of trying to pick value stocks (strategy of FA) because “they are not going to be able to pick the right price and the right time”.

Coming from the Oracle of Omaha, this seeming contradiction can throw you off. But, what he is really saying is that both these investing strategies are in fact correct, but they apply to two quite different types of investors. Value investing is the correct approach for professional investors, whereas portfolio diversification with index funds is correct for the armchair kinds.

A savvy investor, after finding a potentially undervalued stock, must do extensive study of the company – financial statements, annual reports, latest news etc. – before he can be confident enough to buy the stock. A value investor must also execute frequent trading to replace old overvalued stocks in his portfolio with new undervalued ones.

By contrast, an average investor buys and holds a bunch of index funds from different industry sectors to diversify his portfolio (against market risks), and rebalances the portfolio at least once a year to restore the original proportion of funds. This investing method requires very little time and effort from the investor.

If both are correct, who gets more?

A simple portfolio, made up of a single index fund that tracks a broad market index such as the S&P 500 Index, experiences the usual market fluctuations over short times. Over long time, though, the portfolio guarantees the market return (minus the small operating cost of managing the fund), which was more than 10% over several past decades.

A value investor’s portfolio, on the other hand, is expected to grow (despite short-term fluctuations driven by market events) until the undervalued stocks are priced “right”. The probability of a higher-than-market return increases with the expertise of the investor, and with the time and effort spent in researching the stock’s prospect.

Simply put, an average investor with a portfolio of index funds will certainly get at least the market return over long term, whereas a professional investor with his value stocks has only a chance of achieving a higher-than-market return. And unless the difference is substantial, high costs and taxes incurred from frequent trading can eat into the return, often pulling it down below the market return.

There is overwhelming evidence available that achieving such higher-than-market returns on a consistent basis is an extremely rare phenomenon indeed, because no one can “pick the right price and the right time” year after year after year (if you want proof, I suggest reading Burton Malkiel’s classic A Random Walk Down Wall Street). As for me, I prefer certainty over chance, and have been very satisfied with index funds.

He tried to buy $5000 worth of stocks just before the end of Monday, when the stock market was showing a noticeable slide. Fed was making noises of giving it a boost the next day, so he was correct in thinking that stocks will take off Tuesday on this positive news, thereby netting him a tidy gain.

S&P500 index dropped 20 points by the end of Monday, a 1.55% loss. Federal bank announced a $200 billion loan to the banks the following day, and the index soared 47 points by closing time Tuesday, a whopping 3.7% gain. If my friend were to buy a mutual fund that tracks S&P500 index, he could have made 3.7% in a single day!

So, what went wrong? He failed to time his buying. He did send the money before the end of Monday, but the transaction could not be completed before Tuesday, when stocks were already near their peak. And by closing Wednesday (today), the index is again down 12 points, and so he actually ended up losing money.

If I were him, I would have spread $5000 into several small transactions over the entire month, which increases the odds of riding at least one wave from the bottom to the top – the standard advantage of dollar-cost averaging. What is more, you can automate the process, and do not have to spend any time trying to track the market.

This is still only a scratch on the surface compared to what happened this day 20 years ago. In what is now termed the infamous Black Monday, US stock market recorded the largest one-day crash in its history on October 19, 1987. That fateful day, Dow Jones crashed 23%, and S&P 500 dropped 21%.

Dow would have had to lose almost 3200 points today to match a 23% loss. That is a huge number for a single day drop. Can it happen again? Theoretically yes, but unlikely. There is still controversy on what exactly went wrong on black Monday. But there are several safety measures in place today to prevent a similar catastrophe. This includes improved monitoring of stock trading, and also computerized access that allows investors to execute transactions by themselves.

But increasing globalization over the last few short decades have changed the financial landscape of the world. These days markets across continents quickly respond to each other’s turmoil, so much so that the day-to-day fluctuations are considerably more correlated than before. To give one example, the largest slide of this year happened on February 28, when major US indices fell an average of 3.5%, reacting to a 9% drop in Chinese stocks the previous day.

Be that as it may, I still think it is a good idea to have a part of my portfolio allocated to an index fund that covers a broad swath of foreign equity markets. (I am heavily biased towards index funds because of their small operating costs, and also because they incur less tax.) Even though cross-correlations among domestic and international markets have increased, they are yet to reach a point where the benefit of diversification no longer exists. Given that, such a mixing strategy gives me an easy way to construct a simple but smart portfolio.

The second feature is the big ups and downs - the so called “boom-bust” – that tend to happen every few years. Two recent examples are the technology bubble of 1980′s and the (in)famous “dotcom” bubble of 90′s, both of which burst with a loud bang catching many investors off-guard (see the picture here for the S&P Index). For those with a relatively short term investment horizon, getting hit by a recession and losing much of the asset within a few days can hurt.

The third (less explored) feature is the day-to-day fluctuations, the sawtooth pattern of little ups and downs. A great thing about them is the market’s surprising resilience – a fall is almost always followed by a rise, as if being constantly pulled to the underlying trend by an unseen force. To see an example of this daily gain/loss pattern, let us again look at the S&P data (even though Dow Jones Index is the favored child of Wall Street, many prefer S&P 500 because of its broader representation of the market).

The graph here shows the difference of today’s and yesterday’s closing values relative to yesterday’s value (in %). An interesting thing is the near symmetry about the horizontal 0-line. There are as many ups as downs, and they often appear in pairs. A striking example is the largest single-day crash of 21% registered on October 19, 1987, followed within days by the biggest (in the recorded period) one-day gain of 9%. (If we plot the difference between today’s closing value and the average value of the entire preceding month, the result still remains largely the same.)

Another way to look at this alternating sequence of fluctuations is by plotting the distribution of the gain/loss values (a “histogram” plot). The picture here shows this histogram, which is tightly bunched around zero. The large peak near zero indicates that most fluctuations are relatively tiny, and the rare big events lie on the outer “tails” of the distribution. The second histogram on the right shows how many times a loss (or gain) is followed by another loss (gain) on successive days. Most of the time an up occurs right after a down, and rarely does a loss (or gain) continues for as long as a week. Some people prefer using a statistical concept known as the “1-lag autocorrelation coefficient” to quantify such random fluctuations. A value of this coefficient close to zero means one cannot predict with any degree of certainty that a loss today will be followed by another loss tomorrow. For our data, this value is 0.077, which is as near zero as one can get.

To wrap up (this little self-tutorial), there are two take-home messages from this analysis. First, there is no reason to lose nerve after a crash, no matter how precipitous. The market inevitably recovers, often on the very next day, and in fact it registers strong gains over long term. Those poor souls who cleared out soon after the 1987 crash did the worst thing imaginable: selling off when the market has bottomed out. By contrast, the lucky (or prudent) few who held on through the turmoil recovered their asset (and then some) within the next decade. The second bit of wisdom is that no one can consistently time the market. It is easy to get lucky once in a while, but a next-day predictability quotient of 0.077 means that this is also a surefire way of getting burned.