Good Investments in a Bear Market?

[iheartskins]

Coward.

Actually, I have to admit, there's something to be said for the idea of taking huge highly leveraged risks while young.

If you win, you're the next George Soros.

If you lose, declare bankruptcy, and you've got your whole life to make it up...

I don't know if you know this but Cox just specifically barred naked shorts in Frannie/Freddie and certain other financial firms.

Now that's not to say you could get synthetic exposure through a swap or a note of some kind.

I think the highly leveraged risks are fine, as long as it's not your money (just kidding, mostly) and you're sufficiently hedged.

[DjTj]

Coward.

Actually, I have to admit, there's something to be said for the idea of taking huge highly leveraged risks while young.

If you win, you're the next George Soros.

If you lose, declare bankruptcy, and you've got your whole life to make it up...

If only I weren't so risk-averse...

I've got half my 401(k) going to an S&P 500 index fund, and any extra money is paying off debts - there's no more safer investment than that, and the return is better than any CD.

[techboy]

techboy--just a couple thoughts about your theories--I think they are pragmatic, reasoned advice for your average investor--but I assure you that there are CTAs and CPOs out there that blow the doors off the bar with their performance, some with relatively low volatility.

I know there are, but there are a couple of things about that.

1) Some of those people, like David Swenson at Yale (a big advocate of indexing for the common investor, by the way) or Warren Buffet have unusual advantages the investor can't replicate.

Swenson, for instance, does, indeed, "blow the doors off", but I think a large part of that is that he has the huge assets and prestige of Yale, which gets him a lot... Funds charge him less (sometime much less) in fees, for instance, just to say that Yale invests with them.

Buffet, I think, does well mostly not because of investment savvy, but rather business savvy. One apt description I saw is that he's a poker player, when stock picking is blackjack. He takes over businesses, and runs them himself. This adds real value beyond just proper stock picking.

So, unless someone here is either the head of a multi-billion dollar prestige fund or has the business sense and skill of Buffet (in which case they aren't taking investment advice on a football message board), this doesn't really help.

2) I am leery of the idea that anybody really does "blow the doors off", long term, as a matter of skill rather than luck (without some non-picking advantage as listed above). The research just seems to be too strong against such a consistent ability.

One of the issues, here, is that simple random chance is going to produce a few people with long term glowing track records. In a football stadium full of people flipping coins, somebody is going to flip heads 100 times in a row. How do we seperate even a really long term success record from such simple, random chance, especially in light of the research that suggests that such a feat is impossible?

The story of Bill Miller is an interesting example. From Is Bill Miller Toast? in the Washington Post a few days ago, an excerpt:

Talk about a fall from grace. Legg Mason Value, managed by the once-revered Bill Miller, has performed so poorly the past two and a half years that Morningstar now gives the fund one star, our lowest rating. But should it really come as a surprise that Miller, who was once the talk of the investing world because he beat the stock market 15 consecutive calendar years, has hit a rough patch? No. The streak merely masked Miller's bold approach to stock picking, a strategy that was sure to run out of steam at some point.

Two years ago, Miller was a genius, with an unparalleled 15 year record. Now he's a chump? I guess it's possible to explain this as his being a true investment genius, who just hit a rough patch (or whose long-term strategy is effected by short-term trouble, or whatever). Or, it's possible that he flipped heads a lot. How can we tell for sure?

Or, consider the multitiude of hedge funds that have oversized returns for years, then just disappear because it all blows up. Sure, the ones that are left do well, but that's just a form of survivor bias.

Consider The Difficulty of Selecting Superior Mutual Fund Performance. The abstract:

-Much has been written about the management of mutual funds and active versus passive management. This study attempts to quantify the relative performance of actively managed large- and mid-cap domestic stock mutual funds with a passive strategy during a 20-year period, including 11 10-year rolling periods.

-During the study period, most actively managed large- and mid-cap mutual funds underperformed their respective passive strategies. While every period under review had mutual funds that outperformed the passive strategy, few funds did so consistently.

-Furthermore, predicting in advance which mutual funds would outperform was difficult, if not impossible, and the cost of selecting the "wrong" manager was high. These factors combined demonstrate the difficulty for financial planners to select superior performance.

-The study also reviewed the impact of taxes on large-cap investments.

Finally, the author provides recommendations for financial planners in discussing action steps regarding clients' portfolios.

Emphasis mine.

Maybe there are people out there that consistently beat the market without a Swenson/Buffet style advantage (or insider trading), but how can we tell the difference between that and random chance? How do we know if we're getting the Bill Miller of 2004 or the Bill Miller of 2008?

For anyone that wants to put a little time into it, The Evolution of an Investor is a rather long, but excellent article about Blaine Lourd.

He started out on Wall Street as a broker, and over time became more and more disenchanted (and guilty) over how much he was costing his clients by encouraging market timing, even as he was lining his own pockets and those of his firms.

I'm with Blaine Lourd.

[techboy]

If only I weren't so risk-averse...

The key to any successful long-term strategy, though, is to know one's own risk-aversion (as Ferri notes in the quote earlier). It's good that you do, because it's when you don't that you make stupid and costly mistakes.

I've got half my 401(k) going to an S&P 500 index fund, and any extra money is paying off debts - there's no more safer investment than that, and the return is better than any CD.

This is an interesting point. In theory, a mortgage or other loan is a negative bond, where paying it down provides a bond-like return. This means that, technically, an investor whose mortgage or other loans have rates which exceed those of earned by bonds should actually be 100% stock, with the bond allocation going to pay down the mortgage.

I don't know anyone that actually does that, though. 100% stock feels risky, even if it's not technically 100% stock.

Also, location can complicate things, in that bonds should be held in tax-advanaged areas like a 401(k) or an IRA, and you can't really use that money to pay off the mortgage.

[iheartskins]

Well, without getting into specifics, I am aware of at least 50 private funds managers that have "beat the market" for more than 15 years, and most of them, I hazard, are not control/activist investors like Buffett or Icahn (though they are of different stripes) and certain of their followers.

As far large institutional investors with big returns, consider some of the large pension funds that invest in Blackstone, TPG, Caryle et al--many of these pensions/endowments did not get as good of fees as you would think, yet they still have done quite well through a number of different markets. In fact, certain tax rules cause private endowments to be problematic for real estate opportunity funds (among other strategy funds) and they are sometimes refused for that reason if they aren't committing enough capital. Obviously, if Yale is investing $200 million or more, then people listen, but they also listen and give MFN/better rights if Calpers, Calsters, Nycers or Txyss or other major pension funds come in for $200 million.

I worked on the launch of a series of funds for a follower of Bill Miller's--so I'm familiar with his story. While Morginstar is relied on by many retail investors, it's not quite the bedrock of institutional investor analysis (or really a testimony to the commentary/prevailing sentiments of the hf/pe/ric fund space in general, IMO). So I'm not sure I believe that Morginstar rating holds much weight as reflective of Miller's reputation in the investment management business.

I know you're a major proponent of the EMH, and to some degree, I agree with you--but there are definitely people that continually do better, even in products like commodities because, among other things, they are able to take advantage of volatility.

[Fergasun]

If only I weren't so risk-averse...

I've got half my 401(k) going to an S&P 500 index fund, and any extra money is paying off debts - there's no more safer investment than that, and the return is better than any CD.

Dude, have you looked at S&P 500 performance lately? You are getting *crushed*.

Personally if I had money that I was going to use to play the stockmarket I'd look into some ETFs. If you think oil is going up there is an ETF to play that, if you think it is going down there is an ETF to play that.

I'm putting most of my extra money into Gold... in fact I think my credit card's are low interest so I'm not even paying them off too aggressively... in a period of monetary inflation where dollars are trending down its better to pay off debt with the cheaper dollars of the future, kind've piggybacking off of gains.

I've also invested in a number of alternate energy ETFs, wind/solar, but I think we have a long way to go before all of the equities are de-leveraged. Right now everyone is still overly leveraged and for those who don't own a house the best way to gain from all of the government bailouts is to own something else, just anything but dollars!

Smart people I should've listened to were discussing a doubleshort financial ETF that just made something like 100% over the past 12 months!

[The Sisko]

I hear you Techboy and iheart. I haven't gotten to the point where I'm considering going to cash however, this is about as worried as I've ever been about the economy. In the past, during the Saddam selloff and post 9/11 for example, buying was easy as it was pretty obvious to me that these were temporary blips that presented great buying opportunities. However, this time around it's taking some real intestinal fortitude to "keep my powder dry". Thanks for the info.

[techboy]

While Morginstar is relied on by many retail investors, it's not quite the bedrock of institutional investor analysis (or really a testimony to the commentary/prevailing sentiments of the hf/pe/ric fund space in general, IMO).

Well, yeah, I agree with you there. It was just a convenient article. The issue here is that Miller's amazing track record (which, actually, might not be so amazing if compared to the proper index, which is not the S&P 500, but that's an aside) has come to an end. Skill or luck? How can we tell?

I know you're a major proponent of the EMH, and to some degree, I agree with you--but there are definitely people that continually do better, even in products like commodities because, among other things, they are able to take advantage of volatility.

Well, maybe, but there's a lot of research that disagrees with that. From Malkiel's The Efficient Market Hypothesis and its Critics:

A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, see Eugene Fama’s (1970) influential survey article, “Efficient Capital Markets.” It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial information such as company earnings, asset values, etc., to help investors select “undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks with comparable risk.

The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.

The way I put it in my book, A Random Walk Down Wall Street, first published in 1973, a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts. Of course, the advice was not literally to throw darts but instead to throw a towel over the stock pages – that is, to buy a broad-based index fund that bought and held all the stocks in the market and that charged very low expenses.

By the start of the twenty-first century, the intellectual dominance of the efficient market hypothesis had become far less universal. Many financial economists and statisticians began to believe that stock prices are at least partially predictable. A new breed of economists emphasized psychological and behavioral elements of stock-price determination, and came to believe that future stock prices are somewhat predictable on the basis of past stock price patterns as well as certain “fundamental” valuation metrics.

Moreover, many of these economists were even making the far more controversial claim that these predictable patterns enable investors to earn excess risk-adjusted rates of return.

This paper examines the attacks on the efficient market hypothesis and the belief that stock prices are partially predictable. While I make no attempt to present a complete survey of the purported regularities or anomalies in the stock market, I will describe the major statistical findings as well as their behavioral underpinnings, where relevant, and also examine the relationship between predictability and efficiency. I will also describe the major arguments of those who believe that markets are often irrational by analyzing the “crash of 1987,” the “Internet bubble” of the fin de siecle, and other specific irrationalities often mentioned by critics of efficiency. I conclude that our stock markets are far more efficient and far less predictable than some recent academic papers would have us believe. Moreover, the evidence is overwhelming that whatever anomalous behavior of stock prices may exist, it does not create a portfolio trading opportunity that enables investors to earn extraordinary risk adjusted returns.

Emphasis mine. Malkiel argues (persuasively, I think) that there are no significant risk-adjusted opportunities. I think this adequately explains the hedge fund earning 30% a year, especially given the numerous funds that fail. I also like the blind-folded monkey imagery.

I still tend to think that the success stories you refer to are probably statistical outliers, even if they succeed for more than 15 years. Think how many more have tried and failed. How many flame out on Wall Street? I suspect some serious survivor bias is at work, here.

More importantly, even granting that a few might really be able to do it, despite all the evidence to the contrary, how does the average investor, who is not such a genius himself (else he wouldn't need to look) tell the difference? How can we tell the difference between skill and luck, when all we can go on is past performance?

The study I cited earlier, says we can't. That's telling, not only because it indirectly argues that the skilled people don't exist (why else can't we find some way to predict them? Predicatble results based on skill seem possible in other fields...), but it also means that even if they do exist, it's no help to us schlubs on Main Street instead of Wall Street.

Anyway, I suppose I'd actually call myself most accurately a "skilled investor agnostic". They might exist, but I don't think you can prove it, though I remain open to further data.

Still, this seems to be largely academic, given that we seem to be largely in agreement when it comes to the typical investor.

[techboy]

Dude, have you looked at S&P 500 performance lately? You are getting *crushed*.

I know it's hard to believe, especially at the time, but for the long-term investor, most of the money is made during bear markets. That's not a guarantee, of course, but what in life is guaranteed? Unless the entire U.S. economic system goes under (in which case, we'll have bigger problems than our portfolios), DjTj will be fine (or even better than fine), if he's got a sufficiently long time horizon.

The only money he's "losing" is that which he isn't getting by missing out on "obvious" deals like shorting financial ETFs.

Smart people I should've listened to were discussing a doubleshort financial ETF that just made something like 100% over the past 12 months!

The problem with active strategies is that it's not enough to be right once. You have to be right over and over and over again, over your whole lifetime. And, you have to be right even more, because trading costs more money than holding. And, you have to be right more than most, because simple mathematics dictates that the "market" is just the average of everybody's returns, so you have to beat that.

Remember that for every buyer there is a seller, and both think that they are getting a good deal.

If you think you can do all that, good luck.

[Fergasun]

techboy,

I'm sorry but have you looked at the volume? I just don't buy into the theory that stocks "always go up". I think most of the gains to the stock market was the fact that they became more accessible to people, so there was a lot more liquidity added to the system. Now that "everyone" puts money into the stock market I just don't see how it also can keep going up.

[Fergasun]

techboy,

Another thing to keep in mind is that stock market trades for the most part aren't retail investors like you and me. I'd bet that the volume is made on "black box strategies" that people setup for their money and they buy and sell based on "technical signals".

[DjTj]

Dude, have you looked at S&P 500 performance lately? You are getting *crushed*.

If I owned a lot of it, I'd be getting crushed, but I didn't start putting any money in until a few months ago, so I'm buying low. If things go well (poorly), I will be able to buy even lower over the next few months.

The problem with active strategies is that it's not enough to be right once. You have to be right over and over and over again, over your whole lifetime. And, you have to be right even more, because trading costs more money than holding. And, you have to be right more than most, because simple mathematics dictates that the "market" is just the average of everybody's returns, so you have to beat that.

Yeah, it all sounds like too much work. My goal right now is definitely to maximize gain while minimizing the time I have to put into it.

Maybe if I had a hundred thousand dollars invested in stocks, I would pay more attention, but with a relatively small stake right now, I can make a lot more money doing my real job than I can playing market. I'd rather bill an hour to a client than spend an hour studying ETF's. :2cents:

[iheartskins]

Well, techboy, what you're getting at is that there's really no sustainable alpha out there, which I think is bogus. Pariticularly if you expand the investment universe to include all types of investment managers including alternative investment managers--

Ultimately, where do you draw the line between bona fide alpha and you're definition of "survivor bias"; I just don't think that gives enough credit to the people that actually have good investment management skills. There's something more to what they do than being lucky.

Profound, legitimate and respected risk management is the key to many of these operations and is, more than for any other reason, why some of the best fail (Amaranth and LTCM come to mind). You don't think Goldman hired most of the Amaranth traders (other than Brian Hunter) because they weren't damn good at their jobs do you?

[techboy]

techboy,

I'm sorry but have you looked at the volume? I just don't buy into the theory that stocks "always go up". I think most of the gains to the stock market was the fact that they became more accessible to people, so there was a lot more liquidity added to the system. Now that "everyone" puts money into the stock market I just don't see how it also can keep going up.

"This time it's different".

I know we've discussed this before, but I'll write it again. As I recall, you even agreed with me, so you really need to think about the implications of what you're saying.

Your comments betray a fundamental misunderstanding of what stock actually is. In the final analysis, stock is not a gamble on a pyramid scheme, where we jump in when it goes up and hope to jump out before it crashes again (though bubbles do occur and some people play it that way).

No, at its very heart, stock is an investment in real companies with real prospect for growth, and in exchange for taking on some of the risks of that company, the investor is rewarded with some of the profits with that growth.

What you are suggesting with the idea that stocks are no longer a "good bet" is that the risk premium paid to investors is going to disappear, and thus investment in companies will cease. In this scenario, the economy totally collapses, cats and dogs live together, total chaos.

No, while it is true that any individual company and stock can crash, as a whole, as long as the economy is growing and companies need new capital, stocks will as a whole pay off.

Probably not as much as they have over the last period, but most sober economists I've read expect roughly a 3 to 5% real return on stocks in the very long run (in other words, after accounting for inflation, and ignoring any short term fluctuations). And, the truth is, that almost has to happen, because if it doesn't, it means that companies are not growing, the economy is dead, and we should all be investing in gold and guns (and bullets!), because we're living in Mad Max territory.

I have a leather jacket, so all I need is a shotgun.

"...in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism."- Benjamin Graham, from The Intelligent Investor

[Fergasun]

I can make a lot more money doing my real job than I can playing market. I'd rather bill an hour to a client than spend an hour studying ETF's. :2cents:

True, but everybit helps when you are in debt. I've heard some stories about doctors and lawyers being in debt for 20 years after school... no? I was very fortunate to get an engineering job out of school. I'm not at all envious of my lawyer brother's hours (60+) or what I'd guess is $75k debt.

[techboy]

Well, techboy, what you're getting at is that there's really no sustainable alpha out there,

That's what Professor Malkiel and I are getting at, yes, which is kind of the same as the night that Kobe Bryant and I combined to score 81 points against the Raptors.

You don't think Goldman hired most of the Amaranth traders (other than Brian Hunter) because they weren't damn good at their jobs do you?

The things that are being said about Goldman now could easily have been said about Bear two or three years ago.

Really, though, from what I understand (and I'm sure you know more than I do, on this score), Goldman's very opaque in its investment strategies (for obvious reasons... for one thing, assuming true arbitrage opportunites exist, publicity kills them). That makes it hard for me to say if there's

1) some kind of other advantage like Swenson at Yale enjoys

2) It's actually higher risk that they're not disclosing (and it could all come crashing down some day)

3) They really are smarter than everyone else

I know they argue 3. They may even believe 3. I'm not convinced, though.

[Fergasun]

techboy,

I think everything is over-leveraged right now. Yes, I guess my position has, uh... evolved recently... but you can get 3-5% return on investment with CDs or bonds, no? In general I think if you are going to buy stocks index funds are the way to go... but I'm not convinced "buy and hold" is a great strategy in the long run anymore.

I actually think you can make money trading off of the volatility in the stock market, and while I'd like to employ this strategy don't have any experience. Although I suppose the best way to play stocks is still pure fundamentals, but not that many people have the patience or resources to look into fundamentals.

SKF was the ETF that made a killing recently. 57% YTD return!

[DjTj]

True, but everybit helps when you are in debt.

But at the same time I don't feel like I can trade that much risk for reward when loans are hanging out there. Maybe I could chase bigger gains through commodities or particular industry sectors, but I am guaranteed a pretty decent return when I just pay down my debt.

I've heard some stories about doctors and lawyers being in debt for 20 years after school... no? I was very fortunate to get an engineering job out of school. I'm not at all envious of my lawyer brother's hours (60+) or what I'd guess is $75k debt.

I plan to pay it off within 5 years. Maybe then I'll start thinking more aggressively about investments...

[techboy]

techboy,

I think everything is over-leveraged right now. Yes, I guess my position has, uh... evolved recently... but you can get 3-5% return on investment with CDs or bonds, no?

No, not real returns (after inflation).

Look, fundamentally, CDs can never equal stocks. Neither, for that matter, can Treasury Bonds. The reason is simple: these are as close to a risk-free investment as you can get. That's why you like them, right?

That means that in order to entice investors, riskier investments like stocks must offer more returns. Why invest in a risky asset when a risk-free asset pays the same? That's the risk premium I mentioned earlier.

In such a scenario, long-term, where T-Bills and stocks are paying the same, one of two things will happen. Either T-Bill returns go down (because of all the new investors jumping into them) or stocks go up.

Fundamentally, it's the only way the system works, and as I said, if the risk premium goes away permanently, so does the economy, and we have a lot more things to worry about than retirement.

[The Sir]

It depends on what you want to do with that money exactly. If you want to become rich, check out a company called Hall of Fame Beverages and thank me later. It's high risk, but if you research the company, it's hard not to expect big things in the future.

[Burgundy Burner]

After looking at this thread and studying it for a while, I decided to give my two pennies worth.

The advice from various posters here is ok. It's not what I would do or recommend to the OP (who happens to be 21 years of age). Nor would I recommend any of these strategies to friends. No offense to anyone here, but get rich quick ideas, trying to guess a bull or bear market, going with trendy ideas, being a contrarian, trying to read charts, etc., etc., etc. usually leaves investors frustrated.

I'm not claiming to be an expert, but I was given some solid advice twenty-three years ago and the strategy works. It profits in any market. It never fails. The returns are always rock solid.

The strategy? It's simple...

I have a portfolio of companies that have been around a long time and provide dividends every month and every quarter. I'm not talking about companies that are widely known and give out dividends on a regular basis (although, some are good and provide healthy dividends). These are companies that have been around for a long time and never have a negative earnings period. Their dividends are very healthy (many pay in the 8% to 14% range quarterly - some will pay more).

These dividends add up quickly and should be re-invested back to the stock. At age 21, you can start this plan now and retire before you turn 50 - easily. Of course, you can continue to re-invest and have an even better retirement.

My advice is to spend a year or so and research these stocks. They're easy to find and easy to obtain. Keep them and hold them forever. When the time comes, you can live off of the dividends - with considerable ease.

Wishing you the best with your investing strategies.

[sjinhan]

I just bought myself some Chesapeake... which is a natural gas play... I would try to get in when CHK has another pull back (it just had one last week)...

[Gator Bait]

Thats probably going to end up being a pretty brilliant move.

yeah...I've got mine at 18% right now....I want to retire early!

[Hubbs]

Burner, that was a great post. Are there any particular companies in your portfolio that you would strongly suggest?

[techboy]

The strategy? It's simple...

Actually, there are several factors that make it not quite so simple, and of which people should at least be aware.

1. I suspect that at its heart, if this strategy succeeds, it's due to the "buy and hold" nature, which studies of course show is far more likely to succeed than market timing. On the other hand, such a strategy still comes down to correctly picking stocks, and if such a strategy could consistently beat the market with similar risk, surely one of those professional money managers in the study I cited would have hit on it, yet none of them consistently beat the market. It's important not to confuse good returns with the best returns. It's probably "good enough", but why settle?

As a side note, it's also important not to overrate dividends. They are more obvious, but an investor is wisest to look at total return, i.e. dividends plus NAV appreciation.

2. That being said, it's possible there is something to this. I recently came across a reference recently to a study by Malkiel that said that if a person held just the dividend producing stocks of the S&P 500 rather than all of them, that person would have earned a 1% higher return (or something like that).

However, I think it's important to consider why that might be so. It's likely that such an effect is due to something called the "value premium". This effect, found by researchers like Fama and French (referenced earlier, also big on efficient markets), shows a consistent outperformance of "value" (and small, actually) stocks over the market as a whole. Further, that effect appears to be persistent across different markets around the world over at least the last 100 years.

Bearing out this idea is the fact that in certain asset classes where actual value indexes are not readily available, so-called dividend weighted indexes are often recommended as substitutes. An example of this would be the international small value sector. There's no international small value index ETF or fund readily available to the public (DFA, Fama and French's company offers one, but it's only available through a DFA-approved advisor), so many use Wisdomtree's DLS, an international small cap dividend weighted fund as a substitute. I am one such. Dividend paying stocks tend to be value stocks, such as financials. Growth stocks don't tend to need to entice investors with high dividends.

The problem is, at least a big part of the reason for this outperformance is likely to be that such stocks are riskier. As such, though many financial advisors recognize the small and value premiums, I'm not aware of any that recommend all of the portfolio be in value. It's too risky. 40% towards small and value is considered a highly aggressive tilt, and your plan would be 100%!

So, it's important to understand that this strategy may be more risky than you think it is (More on this later). Assessing risk properly is key to investing.

3. Buying individual stocks requires a broker, and thus incurs trading costs, which can be quite high if you buy a lot of different stocks (which you will have to, see below).

4. Besides the fact that even a year of research isn't likely to help with stock picking when the pros by all accounts can't do it successfully, dividends are not certain going forward, even with a long track record.

GM just eliminated its dividend for the first time since like 1924. Even an amazingly long history didn't help there.

5. It is my understanding that dividend payouts are far less today than they have been historically. Companies are moving more to things like stock buybacks, apparently.

6. Dividends are taxed immediately, while stock appreciation isn't taxed until the end, if then (obviously only important in a taxable account). Actually, if stocks are kept until death, taxes are often never paid, as heirs can receive a stepped up basis. *EDITED* This is not true of DRIP plans, which are treated as new stock that adds to the cost basis, not cash payments which can be taxed. It is still true if one does not participate in some sort of Dividend ReInvestment Plan. If you see the cash, even for a minute, Uncle wants his piece. *EDIT DONE*

Right now, the tax on dividends is pretty favorable (15%), so that's good, but the political situation could change soon, so there's a risk there too.

7. Finally, the huge risk with holding individual stocks is the risk of not being properly diversified. The market does not compensate investors for risk that can be diversified away. * So, if you hold only 5 or 10 stocks, you're taking a risk that you're not being compensated for. Personally, I don't like taking risks I'm not being paid for.

Holding enough stocks as an individual, though, to be properly diversified can take a lot of money. So, while a really rich investor can probably lower costs by holding a bunch of individual stocks, a person in his twenties probably can't afford to. Many financial experts cite 15 as the bare minimum to eliminate uncompensated risk, but that number is apparently going up recently as the markets become more correlated with each other.

Further, as Bernstein explains in his short paper The 15-Stock Diversification Myth, it takes a lot more stocks than even first apparent.

The reason is simple: a grossly disproportionate fraction of the total return came from a very few "superstocks" like Dell Computer, which increased in value over 550 times. If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market. (The odds of owing one of the 10 superstocks are approximately one in six.) Of course, by owning only 15 stocks you also increase your chances of becoming fabulously rich. But unfortunately, in investing, it is all too often true that the same things that maximize your chances of getting rich also maximize your chances of getting poor.

If the O’Neal data are generalizable to stocks, and I believe that they are, then even 100 stocks are not nearly enough to eliminate this very important source of financial risk.

So, yes, Virginia, you can eliminate nonsytematic portfolio risk, as defined by Modern Portfolio Theory, with a relatively few stocks. It’s just that nonsystematic risk is only a small part of the puzzle. Fifteen stocks is not enough. Thirty is not enough. Even 200 is not enough. The only way to truly minimize the risks of stock ownership is by owning the whole market.

Anyway, I think it's important that people understand the risks inherent with such an approach before trying it. It's really not that simple.

* I'm sure someone's going to ask, so here's what I mean by the idea that the market won't compensate the investor for risk that can be diversified away.

Remember that the reason equities pay more in the very long run is that there is a "risk premium". Stocks are riskier than CDs or Tbills, so companies have to pay more to incentivize investors to buy stocks instead of CDs or Tbills. The problem is that while buying one stock is very risky (see Enron), it's possible to diversify that risk away by holding lots of stocks. If one goes under, it doesn't hurt much because the other stocks in one's portfolio are still fine, probably. As such, an investor with a large portfolio isn't taking as much risk, and so will be willing to accept less compensation. Companies aren't in the habit of paying out more of their profits than they have to, so they pay that lower amount to the properly diversified investor.

Thus, a person holding only a few stocks is taking a risk he or she is not being paid for.