6th May
written by simplelight

Newsweek has a fascinating article by Fareed Zakaria. Some of the interesting points he makes:

  • 20 years ago the US had the lowest corporate taxes in the world. Today the US has the 2nd highest.
  • Only three countries in the world don’t use the metric system: Liberia, Myanmar, and the US.
  • In 2006 and 2007, 124 countries grew their economies faster than 4%.
  • The share of people living on $1 a day has plummeted from 40 percent in 1981 to 18 percent in 2004
  • The global economy has more than doubled in size over the last 15 years and is now approaching $54 trillion. Global trade has grown by 133 percent in the same period.
  • In World War II Germany suffered 70 percent of its casualties on the eastern front yet the American narrative is one in which the United States and Britain heroically defeat the forces of fascism.
24th October
written by simplelight

I have long held that one of the pillars of long term investing success is not lining the pockets of mutual fund managers. Matthew Hougan recommends an extremely simple, low cost portfolio with a blended expense ratio of 0.148%.  This would represent an excellent start for any beginner investor. I haven’t calculated the blended expense ratio of my recommended portfolio but it is probably close to 15bp and slightly more complex.

20th March
written by simplelight

Buffett’s annual letter to Berkshire Hathaway’s shareholders is always compelling investment insight. His 2006 letter contains this gem:

In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive his bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee. […]

Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the  money.

I have written about this broad daylight heist before but it continues to astonish me that people aren’t aghast at the inequity of the system.

8th December
written by simplelight

The advent of Christmas is always a great time to count your blessings and review your charitable giving. I highly endorse Opportunity International. They make a significant difference in the lives of the poor by loaning them capital with the training and spiritual support that they need to lift themselves out of poverty. Opportunity is close to making their millionth loan to the poor. The average first time loan amount is $84 and the loans have an astonishing repayment rate of 98%. Best of all, it’s a gift that keeps on giving as your contributions are recycled again and again as Opportunity builds up a larger and larger base of capital to loan out.

27th November
written by simplelight

Bank of America (with a horde of other banks on its heels) launched its Keep the Change promotion a year ago. Since then, 2.5 million people have been suckered into this folly. Unless you lack even the basest levels of discipline, this is a bad way to save. These days even checking accounts pay interest and there is virtually no reason for your money to languish in a savings account. Even if you do like to keep a rainy day emergency fund in cash, a money market account is a far better option for temporary savings.

Interestingly enough, the Keep the Change promotion was the cunning invention of IDEO (an outsourced design operation) after Bank of America approached them with a request for “ethnography-based innovation opportunities” (an alarming choice of words even if unintelligible). Apparently the target market was boomer-age women with kids.

Most people should have cash lying around in no more than 3 accounts:

  1. A checking account [day to day cash needs]
  2. A money market account or CD [ 3 – 6 month reserve fund for when disaster strikes ]
  3. A brokerage account [ cash sitting in a money market fund waiting for deployment into your stock/bond portfolio ]

Stashing a few cents a day into a savings account which pays an interest rate below inflation is a recipe for the cat food you will be eating in your old age unless you take charge of your financial life.

15th November
written by simplelight

Many people, after finally saving up a modest nest egg, are faced with the dilemma of what to invest it in. For those who don’t have any interest in spending the rest of their lives following stock tickers and listening to analyst conference calls, the following approach can be implemented extremely easily, is very cost effective, and should take less than 30 minutes each year to maintain.

This approach is suitable for people who a) have saved at least $5,000 and b) are aged 10-60. If you are older than 60 you should probably adopt a more conservative approach. If you have less than $5,000 you should spread your investments over fewer funds else trading fees will dampen your returns considerably.

At a high level, you allocate your investments as follows:

60% stocks

20% real estate

10% bonds

10% commodities

There’s no real magic to this. It just depends on how risky you want your portfolio to be. If you already own a house, I would probably halve the real estate section and increase the rest.

Then the allocation to stocks I break down as follows:

60% US stocks

40% International stocks

That is a good mix given the increased participation in the global economy of the rest of the world and helps guard against currency fluctuations of the dollar.

The US stocks I break down as follows:

33% Large cap stocks

33% Medium cap stocks

33% Small cap stocks

The international equity allocation I break down into:

50% Emerging markets (South Africa, China, India, Brazil, Russia etc.)

50% Developed markets (Europe, Japan, etc.)

For the bond allocation, I recommend a broad-based bond index fund (a mix of long-term and short-term bonds). For real estate you can only really invest in commercial real estate (office buildings, shopping centers, apartment complexes). You then round out your portfolio with an allocation to commodities: oil and precious metals.

Putting that all together works out to the following target portfolio (with ticker symbols and fees of representative index funds in brackets):

12% Large cap US stocks [ VV, 0.07% ]

12% Medium cap US stocks [ VO, 0.13% ]

12% Small cap US stocks [ VB, 0.10% ]

12% International : Emerging market stocks [ VWO, 0.25% ]

12% International : Developed markets stocks [ EFA, 0.35% ]

20% Commercial real estate [ VNQ, 0.12% ]

10% Bonds [ AGG or VBMFX, 0.20% ]

10% Commodities [ IGE, 0.48% ]

If anyone finds a comparable fund with lower expense ratios, please leave a comment and I’ll update this list. For instance, in the emerging markets I have substituted VWO for EEM. The former has fees of 0.25% versus 0.75% for the latter. It should be possible to create a portfolio with a blended fee of 0.14% or less.

I generally prefer the exchange-traded funds as it makes it easier to keep all your investments in one place. I recommend E*Trade for a good blend of low fees, ease of use, and reasonable service. The disadvantage is that you have to pay a fee each time you trade whereas at Vanguard you can add money whenever you feel like without paying a broker fee.

Arranging the list in order of decreasing risk would give:

12% International : Emerging market stocks [ VWO ]

12% International : Developed markets stocks [ EFA ]

12% Small cap US stocks [ VB ]

12% Medium cap US stocks [ VO ]

12% Large cap US stocks [ VV ]

10% Bonds [ AGG or VBMFX ]

20% Commercial real estate [ VNQ ]

10% Commodities [ IGE ]

In the long run, the more risk you take, the higher your returns. The key term is “in the long run”. That’s why as you approach retirement you gradually make your portfolio less risky and weight it more and more towards bonds and fixed income securities. There is plenty of evidence that asset allocation is far more important in determining your eventual return than picking the exact stocks or countries to invest in.

The Barclays iShares web site ( is the best thing since sliced bread and has pretty much everything you need to get started. Most of the funds are index funds which can be traded through an online brokerage like E*Trade.

Always try to find the funds with the lowest fees. High management fees are a vastly underestimated destroyer of long term wealth. You will always pay higher fees for international stocks and the more esoteric funds. You should definitely never pay more than 0.50% in annual fees. The highest fees are for emerging markets funds and specialty funds which should be around 0.45%. The lowest cost funds, like standard S&P 500 index funds, have fees below 0.1%. Fees tend to come down in the long run so keep reevaluating your choices. Always read the entire prospectus for any funds that you invest in so that you know what you actually own.

One slightly tricky part is balancing your asset allocation across your retirement/non-retirement/tax-deferred accounts. Thanks to the complexities of the US tax code there is no way around having three or four investment accounts. A good rule of thumb is to have the investments which pay dividends in the tax-sheltered accounts and the high-risk, high growth assets in the taxable accounts.

Finally, once you have got your asset allocation set up, you need to rebalance it once or twice a year. Since the various funds grow at different rates, eventually your carefully assigned percentages will be all out of whack. One solution is to add your latest contributions to whichever fund is the furthest off at the time. That way you end up investing new money in the funds which have performed poorly recently (buying low). At the beginning of each year, you can spend 30 minutes rebalancing your portfolio to make sure you remain on target. Resist the temptation to go with the latest fad sector. Investing is a long term discipline.

One last comment:

Your investing will dramatically improve if you read a few solid books that lay the theoretical groundwork for choosing where to put your hard-earned cash. I have read scores of books on investing and I would say that the ones that have most shaped my investing philosophy and have enabled me to outperform the S&P 500 for over 15 years are:

  1. Reminiscences of a Stock Operator by Edwin Lefevre
  2. The Intelligent Investor by Benjamin Graham
  3. Common Stocks and Uncommon Profits by Philip Fisher

Buffet describes his investment philosophy as 80% Benjamin Graham and 20% Philip Fisher. Reminiscences is a classic that has stood the test of time because it so accurately describes the emotional traps that lay in wait for the investor.

Advanced Topic

Finally, there is an excellent website, Asset Correlation, which dynamically calculates a correlation matrix for the major asset classes. It is important to check that you are suitably diversified if you decide to tweak my recommended asset allocation.

10th November
written by simplelight

I am an engineer at heart. Now, however, I work in the world of finance. I once asked why engineers in start up companies earn so little despite creating so much of the value. My partner’s answer was disturbing. Engineers, he said, want credit for being smart and that’s what we give them. Everyone else wants money, and that’s what they get.

I have another theory too. I have observed that engineers in private companies often have no idea how much of a company they own. They know how many stock options they have, but they have never thought to ask how many shares there are in the company. I once encouraged an engineer to ask the HR manager what fraction of the company she was being granted with her options. She was told that that information isn’t typically divulged and was advised to treat her options like a lottery ticket. I haven’t bought a lottery ticket recently but I understand that they’re only worth a dollar or so!

If you work for a private company, here’s how you can estimate the economic value of your stock options.

First, you need to answer the following questions (ask your friendly CFO for the answers):

  1. How many shares are outstanding
  2. What was the share price of the last financing
  3. How much common stock is outstanding
  4. How much preference there is in the company and if there is any multiple
  5. Whether the preference has participation.

Ideally, all this information is contained in a one page document called the “cap table” but the company probably won’t just hand it over to you.

What you really want to know is how much preference there is ahead of you. Basically, it works as follows:

Assume there have been 3 financings, series A, B and C. Those 3 financings are all preferred stock and will get paid out before any of the common stock (which is your options). So, as an example, let’s assume that the following financing’s happened:

A: $ 8M
B: $11M
C: $16M

The total is $35M. This is the preference which is “ahead of your options”. Thus, if the company is sold for $50M, the investors in Series A, B, C will first be paid out their $35M and then the remaining $15M will be split amongst the common stock. This is why you need to know what percentage you are of the common stock. Typical %’s of the total stock are

  • CEO: 6-8%
  • VP: 1-2%
  • Dir: 0.5 – 1%
  • Eng: 0.2-0.5%

Sometimes, though, the investments are structured with what is called a “multiple” (1.5x, 2x etc). For instance, a 2x multiple on all 3 rounds of investment would mean that there is actually $70M ahead of you, in which case, the company will have to be sold for $70M before the common stock will start to get paid out since the investors will first get double their money before any of the management team and employees get anything.

The other term often specified is something called “participation”. If the preferred stock has full participation, then, (assuming the 2x multiple) after the first $70M is paid out to the investors, what is remaining is then split between the common stock as well as the preferred stock.

If you’ve read this far and know engineers in a private company who can’t answer the question: “How much will you make if your company is sold for $150M?” then please refer them to this article. There’s no need to unionize. But there is a need to demand information.

21st October
written by simplelight

The internet continues to exhibit an untrammeled elimination of the middleman. A new company,, now allows direct person-to-person lending. I have set up standing orders (one of the best features of the site as it allows automatic bidding on the loan requests) and have created a loan portfolio with an even risk distribution. People submitting loan requests are graded with a risk rating from AA all the way down to HR (high risk) and NC (no credit rating). The risk ratings are based on the credit scores obtained from the credit agencies.

As of writing, Prosper has 90,000 members and has originated over $18 million in loans.

It appears that there is currently a far greater demand for loans than there is a supply of capital bidding on each loan. The implications for my risk-adjusted return are not yet clear, but I think it’s a great idea. 

18th September
written by simplelight

The Chicago Mercantile Exchange recently introduced housing futures and options. This is a long overdue idea and I look forward to the day when it is accessible to individual investors who don’t have membership on the exchange. The derivatives are based on the S&P Case Shiller Home Price Index, which tracks housing prices in ten major US cities. Interestingly enough, you can buy housing futures for 2007 at a considerable discount to today’s price.

11th September
written by simplelight

If you don’t believe that high management fees represent a massive transfer of wealth from the public to the investment bankers who charge the fees then consider the following: You leave college at the age of 21 with a hard-earned engineering degree and your head full of Maxwell’s equations, the Church-Turing thesis and Graham’s Law of Diffusion. Your starting salary is $75,000 per year, grows with inflation, and you dutifully save 5% each year until you retire at the age of 65. By the age of 78 you will have $1,500,000 if you invest in mutual funds which return 7% (a conservative, long-term equity return) and charge you a fee of 2%.

If, instead, you bought a low-cost index fund which returned an identical 7% but only levied an annual fee of 0.2%, you would have $3,000,000 at the age of 78. And your mutual fund manager’s trust fund kid wouldn’t be driving past you in a Ferrari.