2006 Stock Market Year In Review

With the last trading day of 2006 under our belts, it is time to take a look back at how the markets and my 401(k) portfolio performed this year.

Overall, it was a fantastic year for the markets, across almost every asset class. In fact, it would have been difficult to show a negative return in your portfolio this year. This was very upsetting to me. I'll explain why after I walk through some of the details.

70% of my retirement portfolio is invested in Large Cap stocks, with 50% in a S&P 500 Index fund, 10% in a large-cap growth fund, and 10% in a large-cap value fund.

According to Standard and Poor’s Website, the S&P 500 Index rose 13.62% in 2006 and showed a total return (factoring in both capital gains and dividends) of 15.8%. I use the S&P 500 Index as a proxy for the market as a whole, as do many other investors.

My S&P 500 fund showed a total return of 18% this year. I don’t exactly know why it outperformed the returns published on the S&P’s Website, since it is basically designed to track the S&P 500 and I would usually expect its returns to come out slightly lower than the S&Ps because of the fees the fund manager charges. The outperformance may be due to the fact that the fund managers were able to purchase securities at favorable prices, or some timing issue between when they added stocks and when the S&P officially added stocks to its index. Another reason could be that my plan’s Website has not yet completely updated its year-end figures.

Taking a closer look at the sectors that accounted for the S&P’s performance in 2006, the best performers were Telecommunications Services (+32.13%), Energy (+22.22%), and Consumer Discretionary (+17.23%). The weakest performing sectors were Health Care (+5.78%), Information Technology (+7.7%), and Industrials (+11.02%). When the third-worst performing sector in the S&P has double-digit returns for the year, you know it’s a good year for stocks.

2006 was a better year for value stocks than it was for growth stocks, as seen in the performance of my value stock fund (+18.5%) and my growth stock fund (+10%). Value and Growth stocks tend to perform differently as groups so I like to have exposure to both high P/E (growth) and low P/E (value) stocks in my portfolio.

As an aside here, the Wall Street Journal has another proxy for the market as a whole, and that is the Dow Jones Industrial average. I don’t think this is a great barometer for the market because it contains only 30 industrial stocks, but it is a popular gauge. Dow Jones publishes the Journal, so this is the index the paper focuses on the most. The DJIA was up 16% this year and closed near a new all-time high.

The biggest winners of the year were small cap and international stocks. Because I consider these two groups to be more risky than bigger, more well-established American companies, I have lower exposure to them. I keep 15% of my portfolio in small cap stocks, divided among two funds, one of which was up 15.5% on the year, and the other of which was up 7.9%.

12% of my portfolio is allocated to International stocks, with 7% in an international equity fund and 5% in an emerging markets fund. The emerging markets fund blew the doors off of the market this year, recording a 29.4% return. The international fund didn’t do too bad either, returning an even 21% on the year.

If you’ve been adding up my percentages along the way, you’ll discover that I have 3% left. I decided to put a small amount of my retirement money in a fixed income fund purely for the sake of diversification so that in the years when equities are in the red (and I know these years are coming!), I will be able to look at my portfolio and see that at least one of my investments is up. The fixed income fund underperformed my stock investments this year, returning 5%.

My combined rate of return on the entire portfolio this year was a solid 16.6%.

So, am I patting myself on the back for this 16.6%? Am I going to go out and have a party?

I most certainly am not. In fact, I'm pretty disappointed. To illustrate why, here’s a quote from Warren Buffett’s 1997 shareholder letter:

"If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?"Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

I'm definitely a net buyer, so I prefer sinking prices.

While it is a good idea to keep tabs on your investments and year-end provides a good time to take a deeper look at them, the only holding period return I care about is the time period between when I invested my money and when I cash it out. The market could be down 50% next year for all I know, but the reason I am putting my money into stocks is that I think they will end up as my best investment opportunity over the long haul. I hope to average 10% a year over the next 30-35 years, something I could probably never achieve with regular bank account interest, bonds, or other alternatives.

A few other random thoughts about the market this year:

-Most of the market’s gains came in the second half of the year, after the Fed stopped raising rates

-The price of a barrel of oil was up only a penny this year, closing at $61.05 vs. $61.04 at the end of last year. This compares with the $20 a barrel we had become comfortable with in the decade or so before 2004. I never thought I would live to see the day when people expressed relief that oil was “only” $61 a barrel. For most of my life (1986-1999), you could get a gallon of gas for $1.50 at the pumps. For the past few years we’ve been paying more like $2.50, which is a 67% increase that seems to my uneducated eyes like it’s here to stay. If you’re curious about gas prices, check out this website (zfacts.com).

-People seem to be looking for risk. One of the basic tenets of finance is that you get greater rewards if you take greater risks. Judging by how well the riskiest asset classes performed this year (emerging markets being the biggest illustration of this), investors are bidding up these risky assets in hopes of getting these big rewards. Don’t follow the crowd and throw a ton of money at these stellar performers. The other shoe will drop sometime.

-The housing market finally started getting some positive press towards the end of the year. A lot of it came from the National Association of Realtors (NAR), so that can be taken with a grain of salt, but some of the reports on housing starts and home prices have been downright rosy compared with what we had been hearing. Personally, I hope housing prices keep going lower, because I hope to be a buyer within the next few years.

That’s my year in review. I'll close with my wish for 2007:

LOWER SHARE PRICES!

Happy New Year!

The Best Place To Find a Notary

I have never used a notary before in my life, but I need one in order to roll over my old 401(k) plan into my new employer's plan. I thought this would be a huge hassle, but turns out it is only a small hassle. I just called my local Chase bank branch and they have a notary on duty today (Saturday). What great customer service!

Some guy on CraigsList wanted $50 to come and notarize something. I did some poking around and the most you can legally charge to notarize a signature in New York is $2. He must be claiming the $48 is his travel fee!

The point is, your first stop for notary services should be your bank's local branches. If you are paying someone to notarize something for you, look into what your state law says is the maximum fee they can charge.

Postscript: I just got back from Chase, and it was an extremely easy process. They were able to witness my wife's signature, notarize my document, and get me out of there in about 15 minutes. Now all I have to do is make some copies of the signed documentation, send it to the old employer's plan, and they will send me back a check for the amount in my 401(k). I will send this check to my new employer's plan along with instructions for where to invest the money (I am going to distribute it according to the same percentages I use for making my weekly contributions), and they will put it into my account for me. The result? One less account to worry about!

ING Direct's New Electric Orange Checking Account

Lately my online bank, ING Direct, has been dangling its new "Electric Orange" checking account in front of my face. Apparently I am one of a select group of 400,000 of ING Direct's most active customers that make frequent deposits and withdrawals, and they're giving me the opportunity to sign up for the account in January, a month ahead of the national rollout scheduled for February. I have been using the company's Orange savings accounts, its CDs, and even its investment accounts to a limited extent. This new offering is a paperless checking account that pays interest on the your balance according to the following schedule (effective 11/29):

Balance::::::::::::::::::: Interest Rate::::::::::::::::: APY

$0-$49,999.99::::::::::::::::::::::: 2.96%::::::::::::::::::::::::: 3.00%

$50,000-$99,999.99::::::::::::::: 4.94%:::::::::::::::::::::::: 5.05%

$100,000 or more :::::::::::::::::::5.18%:::::::::::::::::::::::: 5.30%

On the surface, this looks very promising, especially if you have a balance over $100,000. Most checking accounts do not pay interest, and to get a 5.30% APY on a checking account is unheard of, especially given the paltry 4.5% APY on ING's own savings account.

When I first saw this account, I immediately thought these were short-term "teaser" rates designed to get people to sign up, only to be ratcheted down a year from now.

Banks are really fighting to retain customers these days, and getting someone to set up a checking account at your bank, automating all of their bill payments through your bank, and basically getting them comfortable with you makes it much more likely that they won't switch. So I figured ING was throwing a teaser out so you would go through the trouble of signing up for another account.

Then I thought about some of the costs (to your bank) of having paper checks. These involve check processing, check imaging, possibly printing copies of your checks in your monthly statements etc... By giving you a paperless checking account, ING saves these costs and can partly pass this savings along to the consumer in the form of interest paid on the account.

Another thing that ING will potentially get from these checking accounts are fees for overdrafts, etc... that it can't hope to earn on a savings account. In addition, the account offers a bank card, and ING can collect some fees from these if you use an ATM that's not in the network.

Combined with the fact that ING doesn't have the overhead the brick and mortar banks have, all of these features allow ING to potentially make money from a checking account that offers such a high rate of interest.

So am I going to sign up for the account?

No.

Why?

Number one, I still harbor suspicions that these rates are a little "too good to be true" and that they will come down to more normal levels after the introductory period is over.

Number two, Chase has already retained me pretty well! I have all of my bill payments set up through that bank's checking account, and I don't relish the idea of redoing all of my payees.

Number three, one of my 2007 goals is to simplify my finances, and I don't think adding another account is a good way to do that.

And finally, even though I don't use them very often, I still use paper checks at least once a month to pay my rent. I like the flexibility of being able to put one into a birthday card or send money through the mail with a paper check. In ING's defense, the checking account does offer an option where you can enter in some information online, and it will generate and mail a check to your recipient, but I'm not entirely comfortable with that process. Chase does something similar but I had them send a check to my brother one time and it took forever. Plus, you can't easily stuff one of those into a birthday card.

The rates are attractive right now, but in this case the negatives outweigh the positives for me. The last thing I need is another account, another piece of plastic with my account numbers on it, and more statements coming to my house.

You can read more about Electric Orange on ING Direct's Website.

POSTSCRIPT: I reevaluated the ING Direct Electric Orange account in May of 2007 and I opened one. See this post for my rationale (its about half way through the post). To make a long story short, it yields the same amount as a 1 year CD, and I had enough cash savings to get the highest offered rate, which is 5.25% APY as of June 2007.

Buffettology by Mary Buffett

Buffettology was among the first investing books that I read way back when I was a 19 year old college senior, and it remains one of the foundations of my investment philosophy.

Mary Buffett was Warren Buffett's daughter-in-law for 12 years and wrote this book following her 1993 divorce from Warren's son Peter (for the sake of clarity, I will refer to Ms. Buffett as "Mary" and Warren as "Buffett" from here out). It gives her "insider" perspective on on Buffett's investing style and offers a fairly in-depth look at how she thinks he makes his decisions.

The book is broken into two main parts- "The Art of Basic Buffettology" and "Advanced Buffettology."

If you think the stock market is about ticker symbols, three week moving averages, relative strength, reading analyst reports, buying, selling, and momentum, then anything you hear from or about Buffett will seem counterintuitive.

Mary lays this out right at the beginning of the book "Warren had little use for typical Wall Street banter. He didn't seem to care which way the Dow Jones Industrial Average went, and he certainly had no use for all the soothsayers and their predictions. In fact, he acted as if the entire stock market didn't exist. He never looked at a chart, and if anyone tried to give him a stock tip, he would usually shut him or her off... He seemed to care only about the individual businesses he was interested in owning."

From the book you will quickly learn that Buffett takes a business perspective to investing. He doesn't think of buying stocks like the way many people think about buying them. He understands that they represent an ownership interest in a business, and evaluates whether or not he wants to own a piece of that business.

Of particular interest in the first half of the book is Mary's treatment of the general kinds of businesses Buffett likes to invest in. According to Mary, Buffett divided businesses into two basic categories - commodity type businesses and excellent businesses.

The commodity-type businesses "offer the least for future growth of shareholder value," and they share some or all of the following characteristics: low profit margins, low returns on equity, absence of brand-name loyalty, the presence of multiple producers, the existence of substantial excess production capacity in the industry, erratic profits, and profitability almost entirely dependent upon management's abilities to efficiently utilize tangible assets. Buffett stays away from these kinds of businesses, she says, because price competition generally reduces profits, and in the event that the business does earn some profits, "the capital is usually spent upgrading plant and equipment to keep abreast of the competition."

The excellent businesses, on the other hand, have something called a "consumer monopoly" going for them. When a company produces products with "some distinctive attributes that are particularly attractive to buyers, who then form an attachment to a company and the products it sells," that company has a consumer monopoly.

Mary lists nine questions to help determine if a business is an excellent one:

"1) Does the business have an identifiable consumer monopoly?
2) Are the earnings of the company strong and showing an upward trend?
3) Is the company conservatively financed?
4) Does the business consistently earn a high rate of return on shareholders' equity?
5) Does the business get to retain its earnings?
6) How much does the business have to spend on maintaining current operations?
7) Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the managment do at this?
8) Is the company free to adjust prices to inflation?
9) Will the value added by retained earnings increase the market value of the company?"

The second half of the book is called "Advanced Buffettology" and takes a more quantitative look at some of the Buffett tools such as projecting rates of return, forecasting future earnings, and playing the short term arbitrage game. To wrap it up, Mary presents a few case studies of stocks that Buffett has actually purchased, and walks through his most likely rationale for making the investments that he did.

Coupled with a reading of Buffett's shareholder letters, this book makes an excellent introduction to the investing style of Warren Buffett. Mary lays it all out in short, distinct modules that make it very easy to pick up the book, spend 10-20 minutes reading, then put it down to come back to at another time.

Since Buffett has never written a book himself, we may never get a perfect insight into how he selects and values stocks. However, I think it is an extremely worthwhile exercise to try to figure it out using the materials available to us. If you are interested, I would recommend picking up a copy of this book and adding to your knowledge of The Oracle of Omaha.

Yearend Financial Tips from Bankrate

Just passing this along...Bankrate.com has a great roundup of financial tips from seven experts for 2007. There should be something here for everyone. I was particularly impressed with the Tax Adviser's roundup, because it did not include a suggestion to "sell your losers!" Kudos to bankrate on some more great info!

Bankruptcy Adviser: 7 steps to a fresh financial start

Mortgage expert: 7 smart mortgage moves for '07

Debt Adviser: 7 moves to get debt-free

Dr. Don: 7 personal finance ideas

Tax Adviser: 7 moves for tax-filing season

Real Estate Adviser: 7 tips for home buying or selling

College Money Guru: 7 steps to save for college

It's That Goal-Setting Time of Year Again

The week between Christmas and New Year's always seems to be a slow one at work, making it an opportune time to take a step back from your life, look at where you've been, where you're going, and maybe set some goals for the upcoming year.

I was just over at Consumerism Commentary reading this post linking to stories about other bloggers' 2007 goals. I had a good time looking at people's goals and realizing how similar they are to mine, and to basically everyone I know. I recommend taking a look at some of these, you just might find some inspiration there.

We all seem to want to exercise more, we want to spend more time with our families, and we want to improve our financial security. I've achieved a few goals in the past and the best advice I can give is to make it a priority, figure out the pitfalls in advance (ie- what are the things that have prevented me from doing this in the past), and start small. If you want to start a new exercise routine or something, be fully aware that the first few weeks are going to be the most difficult, but they are also the most important. The inertia of not exercising, not saving, and not spending time with your family is a powerful thing and you have to hit it like a wrecking ball.

I always make it a point to get into the office at least a few days in the week between Christmas and New Years (if possible) because, since it is usually so slow, it gives you the perfect opportunity to clean up your workspace by throwing out a bunch of old documents and files. It's also a great week to devote a day or an afternoon to the big picture thinking you might otherwise never get the chance to do. For more on big picture thinking and how it can help you, check out this post I wrote.

If you haven't already done so, why not take some time this week to set some goals for next year? The following are some links to help you jump-start your thinking:

mindtools.com
topachievement.com
about.com

Stupid Year-End Tax Advice

Of all the year-end tax tips I see bandied about in the popular financial press, the one that I disagree with most is the advice to sell stocks in your portfolio that have declined in value in order to generate tax losses that can offset capital gains you might be reporting for that year.

I cringe whenever I see an article entitled "10 Year End Tax Tips" or "Seven Ways To Cut Your Tax Bill Next Year," because nine times out of ten, the writer suggests that you "sell your losers."

This advice shows up here (allbusiness.com), here (quicken.com), here (taxprofblog.com), here (turbotax.intuit.com, which presents the advice a little bit more responsibly), here (about.com), here (csmonitor.com), here (taxguru.net), here (money.cnn.com), here (money.aol.com) and in basically every single year end tax planning guide you will ever come across. These year-end tax tip articles usually have the same incestuous few bits of advice that, although they might be helpful in some situations, generally aren't worth the paper or pixels they're printed on.

So why do I call the particular suggestion of selling losers "stupid advice?" Because you should always base your decision to buy or sell a stock on the price of the stock and your estimate of the company's future prospects, not on how the other stocks in your portfolio have performed.

If you own shares of a company, and the value of your investment falls below where you purchased it, you need to reevaluate your investment. Is the company still performing how you thought it would? Has there been a negative change in the fundamentals of the business or its industry? Has the stock simply fallen out of favor? Are investors getting scared? You sell your stake in the company when the fundamentals have changed and your original reasons for buying it no longer apply, and this shouldn't be something you wait until the end of the year to decide on.

If you based all of your financial decisions purely on lowering your tax bill, I could give you some great year-end advice. Tell your employer to stop paying you for your work. This will put you in a lower income tax bracket (the 0% bracket, to be more specific) and ease next year's tax burden. Then take all of your income-generating investments, liquidate them, and put the proceeds into a 0% checking account. This will reduce the interest income you have to pay. Also, try to contract a serious disease or injure yourself so you can deduct all of those huge medical bills.

Hopefully you realized the previous paragraph was me being sarcastic, but the point that I am trying to make is that you should not base your investing decisions purely on the tax consequences because in many cases, the tax benefit of offsetting some capital gains would be more than offset by the future performance of the stock. You are taking a very short-term view when you sell a loser to offset gains, and I would argue that if you're going to make short term bets on stock prices, you might as well go to the nearest casino and at least get some free drinks while you gamble your money away.

In some cases, the advice to sell losers might make sense. If you haven't been paying attention to your portfolio all year (and if you haven't, why are you investing in individual stocks in the first place?), this might give you a reason to reevaluate your holdings. If you're on the fence about selling a stock due to its business prospects, all else equal this consideration might push you over the fence.

Finally, I am not a tax advisor, so you should check with yours before making any decisions with the intention of lowering your tax bill. The preceding was just my sound, educated, correct opinion and does not necessarily reflect the views of the personal finance industry, the blogosphere, or the world as a whole.