BRIC Countries: Brazil (2008-08-25)

BRIC Countries: Brazil

(2008-08-25) by David John Marotta

In 2003, the Goldman Sachs Global Economics Department predicted the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050. These countries have averaged a total return on investment in their stock markets of 38.28% over the past five years, up 5.02% over the past year.

It pays to look outside the United States for investment options. Every portfolio should be crafted to have the optimum amount of noncorrelated assets in order to lower volatility and increase returns. Understanding BRIC countries helps investors and their advisors determine what percentages best meet those goals.

According to the original investment thesis, these emerging market countries have the preconditions needed in an emerging market to encourage sustainable successful development. Their economic strengths should be able to overcome their economic or political weaknesses.

The term "BRIC" has become synonymous with "emerging markets" in investors' minds. But when the acronym was coined, the BRIC countries were perceived as distinct entities. They have never represented more than 30% of the Emerging Markets Index. The three largest countries, representing more than 40% of the index, are South Korea, Taiwan and South Africa.

Over the past five years, the BRIC subset has beaten the Emerging Markets Index annually by a whopping 11.07%. And the index is down 4.36% over the last year, whereas the BRIC index is up 5.02%.

Brazil, the biggest BRIC country, is credited for most of this performance. It has the fifth largest landmass and the fifth largest population in the world. Brazil also has the best five-year return. As of the end of July, the MSCI Brazil Index showed a five-year annualized return of 53.91%, and it is up 32.05% over the past year.

But these returns came with a price. An editorial last month criticized President Lula for "loving investment grade [securities rating] over the welfare of his people." The Brazilian central bank has set the interest rate at 13%, although inflation is only expected to run at about 5%. This has kept Brazil's currency strong. Contrast the Brazil's strong currency policy with the U.S. current interest rates of 2% while inflation is running an actual 5% to 10%. As a result of the difference in monetary policy, the Brazilian real (R$) has appreciated 222% (16% annualized) against the dollar since January 2003. Brazil's conservative monetary policy has helped it lower government debt to 41% of gross domestic product compared with the U.S. debt currently at 70%.

Brazil has potential, but a lack of economic freedom still holds the country back. Graft and corruption are rampant at every level of government. Injustice is commonplace. Who people know determines the amount of bureaucratic regulation they have to suffer. "For my friends, everything. For strangers, nothing. For my enemies, the law." This common Brazilian adage is a sobering reminder of the mindset there.

Starting a business in Brazil takes 152 days, more than three times the world average. Obtaining a business license is difficult. Just going bankrupt takes four years. Such an environment is difficult for most Americans to comprehend.

The resulting extreme inequity between the haves and the have-nots in Brazil motivates the latter group to seek relief politically. More than 30% of the population live below the poverty line and identify with the socialist and communist political parties.

But as political activists press for more laws, opportunities increasingly open up for unequal application by corrupt officials. This blocks the development of commerce. A professional class of intermediaries is required to facilitate introductions and grease governmental red tape. Substituting personal relationships for the rule of law also creates instability, so entrepreneurs hesitate to take risks. As a result, a well-intentioned socialism actually helps perpetuate the opportunity for abuse and inequality.

One area where Brazil has excelled is making headway toward energy independence. The 1973 oil crisis hit the economy particularly hard. During the recession that followed, Brazilians learned the hard way about the importance of energy. Today, Brazil's extensive system of rivers generates about 90% of its hydroelectric power. The country has also developed a large sugar industry to provide ethanol for domestic use and as an export. In the last few years, Brazil has begun drilling for offshore oil and natural gas. So it may become an oil-exporting country.

The United States imposes a $0.54 cents a gallon tariff on Brazilian ethanol made from sugarcane to protect the ethanol made from U.S. corn, currently at $2.90 a gallon. Ethanol made from Brazilian sugarcane at $1.40 a gallon would be less than half the price. But the tariff pushes Brazil to sell to other markets that do not impose a tariff.

Oddly enough, Brazil itself discourages imports through a wide range of nontariff barriers. As the world economy falters, somehow a majority of people in different countries believe they are the losers in free trade, one of the most simple and easy ways to enrich the world.

Today the winds of trade wars are blowing cold everywhere. Politicians need foreigners to blame for domestic economic troubles. Even our own mantra has become "fair trade, not free trade." But the word "fair" is left vague. This is a political advantage; after all, no one favors unfairness. The unintended harm of trade restrictions are difficult to connect to the cause and take years to unfold.

President Clinton should be praised for moving the United States toward free trade. In the fall of 1991 while running for president, he overruled his campaign's internal debate. "Clinton looked up over his spectacles and said, 'I want all of you to understand something: I'm not going to run as an isolationist, and I'm not going to run as a protectionist,'" recalls political theorist William Galston.

Today, Republican presidential nominee John McCain is the heir to the Clinton administration's economic principles. He says, "Every time the United States has become protectionist we've paid a very heavy price. Free trade has been the engine of our economy." His position won't help him any in the upcoming election.

During the Clinton years, a majority of Americans viewed free trade positively. But after the Democrats lost control of Congress in 1996, fear became a political tool. Job loss to foreign workers is an easy target. Specific anecdotal experiences trump clear economic studies. As a result, unions and environmentalists, opponents of free trade, heavily contributed to the Democrats winning a majority in Congress in 2006. Today, 68% of those surveyed in a Fortune magazine poll believe that America's trading partners benefit more than Americans from free trade.

In Brazil, political sentiments appear to be no different, except that we play the role of greedy foreigners. This occurs despite the fact that much of the country's historical growth has been export driven.

Emerging market countries are volatile. Brazil is no exception. A military dictatorship ruled the country from 1964 until 1985; the constitution was rewritten in 1988. A decade later, Brazil experienced a currency meltdown. Then in 2002, Brazil received a record International Monetary Fund bailout it repaid in 2005, earlier than required. Since that time, the real has appreciated tremendously against the U.S. dollar. It is responsible for 16% of the 53.91% annualized real return in the past five years.

Generally BRIC countries don't move in sync with the U.S. markets. The EAFE Foreign Index has a five-year correlation of 0.81 with the S&P 500. The emerging markets correlation is only 0.72, and Brazil's correlation is only 0.58.

We don't recommend that BRIC countries comprise a major portion of your portfolio, but they should be represented. Although any unstable investment can endanger the chances of meeting your financial goals, a small allocation to a volatile investment can enhance them, especially if that investment doesn't move in sync with your other investments.

from http://www.emarotta.com/article.php?ID=298

Behavioral Finance: Patience Is Its Own Reward (2008-08-18)

Behavioral Finance: Patience Is Its Own Reward

(2008-08-18) by David John Marotta

To process financial information, our minds often attempt unwise shortcuts. By understanding behavioral finance, we can limit the information we use and keep our decisions balanced and on track.

Financial information on the Internet is excessive and changes daily. This overload leads to excessive trading, which in turn results in lower returns. Studies suggest that analysts who depend on all this overwhelming advice make poorer decisions even though they feel more confident about them.

Another reaction to information overload is paralysis. When investors have one attractive option, they tend to invest. When they have two or more appealing choices, they may fail to act because they are afraid of making a wrong decision and looking stupid. This regret aversion motivates them to go with the status quo, which is often more costly than either of the promising alternatives.

Over the long term, the U.S. stock markets go up an average of 11% annually, beating inflation by about 6.5%. But to earn this great typical return, studies in behavioral finance indicate that we must be able to tolerate the year-to-year volatility.

In each of the last five years, the stock markets were up. The three years before that (2000 to 2002), the markets were down. Many people worry about the timing of getting into or out of the markets: Will 2008 be an up year? What about 2009?

I will give you the forecast for the next ten years in the U.S. markets: up, down, up, up, down, up, down, up, up, up. These predictions are not in chronological order. This year could be one of the "up" years or one of the "down" years. It is a gamble, but unlike most gambling, the odds are in your favor. About seven of every ten years are up years, and they are usually stronger than the down years.

If you are an investor, the odds are in your favor. But not everyone who buys and sells stocks is an investor. Some people play the markets looking for short-term gains and follow hot tips or quickly timed movements. These people are speculators, not investors.

Compare an investor with an orchard manager who goes to a nursery to buy some peach trees. He buys the trees because he understands about growing and selling fruit. He knows how to care for the trees, harvest the peaches, and deliver them to market. He understands what is involved across the whole spectrum of his business: from nurturing the natural juicy fruit to savoring it baked in a delicious peach cobbler.

Speculators buy some peach trees when they see the nursery's supplies are dwindling. Then they stand in the parking lot hoping to resell the trees at a profit. Speculators do not care what they are buying or selling so long as the price moves quickly. So they never really buy peach trees. Speculators purchase snow blowers when the blizzard is forecast or generators as the hurricane gathers strength, or whatever else they think might show a short-term spike in price.

If the blizzard misses or the hurricane fizzles, speculators lose money. The possibility of more demand raises prices appropriately. If the likelihood increases, prices go up even higher. If the likelihood decreases, so do prices.

As soon as it is feasible, speculators sell quickly because they believe the spike is short lived and temporary. This tendency led to the investment truism "Buy on rumor and sell on news."

In other words, even if speculators are right, their profits depend on being faster to buy and faster to sell. For the speculator, speed is everything. Not so for investors.

Investors, like farmers, substitute seasons of patient labor and care for speed and market timing. They make their money off the gradual growth in the value of their investments. In contrast, salespeople must keep their merchandise moving because their product isn't getting any more valuable. They make their money off commissions on the transaction itself. For them, what is important is the speed and number of transactions. Brokers and those who sell "loaded funds" are salespeople, not peach farmers. Their livelihood depends on the number and rate of trades in an account. These incentives for speed can lead to abuses.

Frequent trading in an account for the purpose of gaining commissions is called "churning," measured by the turnover rate in an investment portfolio. Turnover is the percentage of an investment account's asset that are bought or sold during a year. Churning can be defined as a turnover rate of over 300%, meaning the entire portfolio value is bought or sold every four months.

An important criteria we use for equity mutual fund selection is a turnover ratio of under 50%. We advise you to be patient and try to ignore the market's ups and downs.

Studies show that mutual funds with a lower turnover rate perform better. Short-term trading has a cost and usually reduces performance. To make money, speculators usually must guess the highs and lows in the stock market within six weeks.

This investment philosophy does not depend on what the markets did in the last four months or what they will do in the next four months. We can't imagine a peach tree that would look good to buy and hold for only four months. Investing is like planting a peach tree: You have to wait for the fruits of your labor.

So don't worry too much about the timing of getting in and out of the market. Focus instead on having a diversified enough portfolio to weather any market--up or down. Once you have a brilliant investment strategy, a successful investor's greatest virtue is patience. As scientist and mathematician Georges-Louis Leclerc said, "Patience is genius"--and it is often the best defense against short-term noise that can ruin your long-term results.

from http://www.emarotta.com/article.php?ID=297

Behavioral Finance: Herd Mentality (2008-08-11)

Behavioral Finance: Herd Mentality

(2008-08-11) by David John Marotta

One of the early studies on herd mentality was the Solomon Asch experiments in the 1950s. The setup was a mock vision test. In reality, all but one of the participants were actors, who after a few correct answers started agreeing unanimously on a wrong choice.

In a control group, participants had no trouble answering correctly. But participants waffled when a group of three or more people who preceded them confidently selected a different answer. Three out of four responded incorrectly to at least one question. In the end, participants answered incorrectly about 37% of the time.

First we must acknowledge that the phenomenon of the herd mentality can be useful in many situations. For example, computer simulations show that even when only 5% of the animals in a herd know the location of the watering hole, the entire herd is able to find it. In nature, keeping the number of leaders low helps minimize those who are put at risk. People use these instincts every day as they leave theaters and navigate crowded streets.

Although the herd mentality may help you find greener pastures if you are a bison, it won't help you find untrampled pastures. In investments, every bison ahead of you has already run the price up, and the only buyers of your investment are behind you. Straggling along at the back of the herd doesn't stop you from reaching the watering hole, but being toward the end of a run-up in the markets can be as deadly as drinking from fouled water.

In the original Asch experiments, those who were persuaded to give wrong answers used two different sets of reasoning. One group believed that everyone was trying to give the right answer and they had somehow fallen victim to an optical illusion. The assumption that three presumably honest people are correct and you must be wrong could help you avoid some mistakes. The herd mentality can keep you from wandering off into the desert seeking to drink from a mirage.

The other group gave the wrong answer knowing it was wrong simply because it wasn't worth giving a different answer. Every time they broke the pattern of giving the same answer as everyone else, the cadence would stop and the entire group would look at them. They suspected that everyone else was wrong, but they saw no harm in going along and agreeing anyway. This is how the herd mentality can help your social life.

Even though a herd mentality can be useful in some situations, equity markets isn't one of them. In the markets, the herd effect benefits those at the front of the herd who can sell their place at the watering hole to those at the tail end before too many bison have fouled the water. Being at the tail end of the herd produces regret as the herd moves on, leaving you in a trampled field. But to avoid the pitfalls of this herd instinct in your investments, you need knowledge and conviction as well as an awareness of when you are susceptible to the influence of the herd.

In the original study, at least three actors were required to achieve this herd effect, and they had to be unified. If even one person gave the correct answer, it provided a role model for defiance and the herd effect was reduced. People seemed to need permission to disagree with the herd.

I give you permission to disagree with the herd.

Countering the herd effect is the essence of being a contrarian, that is, an investor who buys a category when most others are selling and sells when others are buying. A contrarian doesn't chase what is hot but often buys a category that has recently underperformed.

Major news sources move markets just by their tone of optimism or pessimism. The financial news often focuses on daily price movements, and like all sports trivia, it tends to emphasize winning or losing streaks.

Stock prices can move on very low volume if it is all in one direction. Even when the vast majority of those who hold stocks continue to hold them, if even a few investors are motivated to buy or sell, the price moves significantly.

In the long term, the markets are brilliant at setting appropriate stock prices. In the short term, though, they have the IQ of a gnat. The markets offer so much inherent opportunity that even conservative investors get swayed by the siren songs of greed or fear. The strait between Scylla and Charybdis is a narrow path safely navigated only if you have a nymph like Thetis to guide you.

In the financial world, your Thetis is a long-term investment strategy and the discipline to purposefully avoid moving in one direction. Not following the crowd describes a contrarian perfectly. And the cornerstone of that role is rebalancing your portfolio regularly.

Imagine you have a $100,000 portfolio consisting of two different categories, A and B. Your wise financial advisor suggests diversifying your portfolio by investing half in each category. At the end of the first year, A has earned 30% and B has just broken even. You now have $115,000: $65,000 in A and $50,000 in B.

You are happy with your investment in A, but you still aren't sure about B. All the financial news is about A's stellar returns, how the industry is booming, and why A's products are essential to life on this planet. The news also reports the slump in Category B. No one is buying their products. They are laying off employees, firing CEOs, and facing a wall of pending indictments and lawsuits.

To make matters worse, your neighbor to the right works in Category A, and his 30% investment returns is all he can talk about. Your brother-in-law is dumping all of his investments in B and adding to his investment in A. So you call your financial advisor and ask if you should make some adjustments in your asset allocation as well.

"Yes," answers your financial advisor, "sell $7,500 of A and invest that in B." You are stunned. You wonder if your investment advisor is so stubbornly enamored by B that she won't admit her mistake and insists on pouring more of your investment gains down the drain.

Although you are not convinced by this so-called strategy, you decide to give it another try. So you sell some of A and buy more B. Now you have $57,500 invested in each.

Fortunes change. The layoffs and new leadership in B return profitability and the industry begins to recover. Stock prices, beaten down because of losses, rebound from their lows, and B gains 30% the second year.

Meanwhile, A's growth falters. Stock prices had been driven up from new investments and were pricing the company for 30% annual growth. When the industry of A only experiences 15% growth, however, the stock prices falter and appreciation ceases. Despite 15% growth, current stock valuations are barely justified and drift sideways for a 0% gain for the year.

Your brother-in-law and your neighbor to the right are tight-lipped.

Your neighbor to the left, however, is ecstatic. He works for a company in B. Not only is his company doing better, his investment made a 30% return this past year!

You are satisfied but not ecstatic. You've never gotten a 30% return. You meet with your investment advisor and ask her, "If you knew B was going to do well, why didn't we put all the money in that category?"

"I didn't know B would do well," your advisor admits. "But when a good category falls out of favor with investors, rebalancing your portfolio is automatically a contrarian investment. Your portfolio returned 15% the first year and 15% the second year. Unlike your neighbors, the second year's gains compounded with the first year's gains produced a total gain of 32.5%."

You are amazed. The simple contrarian act of pulling money out of the investment that was the darling of the industry and investing it in the dogs of the industry boosted your two-year returns by 2.5%. Not only did your investments do better than your neighbors did, but you avoided the feast or famine volatility inherent in their approach.

As a financial advisor, I can often predict which category will perform the best over the next year just by observing the reluctance of new clients to invest in that category. A savvy Rothschild banker once gave this "contrary" advice: "Buy when there is blood on the street and sell on the sound of the trumpet."

It's tough being a contrarian, but investing in trampled on categories is too critical for your investment returns to let emotions or the herd mentality block your success.

from http://www.emarotta.com/article.php?ID=296

Behavioral Finance: Overconfidence (2008-08-04)

Behavioral Finance: Overconfidence

(2008-08-04) by David John Marotta

Think of confidence as a continuum: Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Successful investors seek to find a balance between rashness and timidity. Understanding the psychology that causes us to act overconfidently will help you avoid it.

Before we really understand something, we may either lack confidence or express overconfidence. A common type of overconfidence stems from inexperience. For instance, more than 70% of naive investors wrongly assume they are enjoying above-average returns.

Part of the problem is certainly overconfidence. Research studies indicate that a majority of members of any group will rate themselves above average on a given task. But part of the difficulty may also be what people value in the task.

For example, 82% of students rate themselves in the top 30% of safe drivers. Some new drivers define the quality of their performance by how many accidents they've had. Others use speeding tickets as a measure. And sadly, some young adults consider themselves safe drivers because they can execute trick maneuvers drunk while doing 100 miles an hour. Inexperience often breeds overconfidence.

According to behavioral finance studies, overconfident investors trade more and earn less than those who opt for a buy-and-hold strategy. These brash investors time the market poorly, all the while assuming they're doing better than average. They maintain this delusion by selectively forgetting how they believed all the misleading and confusing indicators that falsely predicted certain outcomes were inevitable. If the outcome happens months later at half what they predicted, they still say, "I told you so." Without calculating an accurate time-weighted return each month, they assume their own brilliance.

We tell stories so we will remember experiences, not forget them. We say, "I don't want to talk about it" because that helps us forget. In investing, we recount our winners and prefer not to talk about our mistakes. This tendency is universal even if we are only reviewing our investment decisions in the confines of our own minds. Thus without a rigorous review methodology, how we remember trumps what actually happened.

Certainly a little overconfidence is better than a lack of confidence. Because the markets on average go up, an emotional bias that keeps us invested helps us earn better returns. Overconfidence that causes us to underperform the market by 2% annually still translates into reaping quite satisfying returns. Therefore overconfidence only becomes dangerous when we can't conceive of failing.

A demotivational poster available at despair.com, entitled "Overconfidence," pictures two downhill skiers trying to outrun an avalanche. The caption reads, "Before you attempt to beat the odds, be sure you could survive the odds beating you." That's sage advice.

Deadly overconfidence causes us to break one or all of these five rules of investing humility:

1. Don't borrow money to buy stocks. The markets are inherently volatile, and your investment strategy must be able to survive a prolonged downturn. If you have purchased stocks by heavily margining your account, you will experience a margin call when your investments drop in value. Being forced to sell equities when the markets are down is a surefire way to lock in losses and lose your shirt. Many options and other investment derivatives also leverage your investments and increase the potential for disaster.

Here's a humbler approach: Err on the side of caution and keep a portion of your portfolio in cash or fixed income. "Keep some dry powder" is the maxim. Having cash to buy back into stocks after a market correction both boosts as well as smooths your investment returns. And thanks to the effect of compounding, smoother returns produce better returns.

2. Diversify. Even if you are right nine out of ten times, if you always bet the farm, then one mistake will lose everything. No matter how confident you are, plan on doing OK even if you are wrong. Diversification means you will always have something to complain about. But it also means you won't make more than half a mistake.

Many investors make their fortunes through a few lucky picks and mistakenly believe they can maintain their wealth the same way. Easy come, easy go. Especially if you got rich by being lucky, you need to wise up and realize you don't know it all. Find an asset allocation that will survive the next 30 years.

3. Avoid correlated investments. Correlated investments all move in sync with one another. Investors at the end of the 1990s believed they were diversified because they had five different large-cap growth mutual funds. They all moved in sync with one another and lost 69% of their value shortly thereafter.

When the correlation between two investments rises, the value of diversifying between them diminishes. Stay alert about events that always appear more unlikely based on historical statistics than they actually are. Past performance always underestimates the actual volatility. Because it is often these unknowns that pose the real risk, take precautions that help protect you no matter what the disaster may be.

4. Keep short-term spending safe. Maintain a cash emergency fund that can provide three months of spending. Keep another three months' worth in safe fixed-income investments. During retirement, keep the next five to seven years of spending in fixed income. This strategy allows you to put the remainder of your portfolio in the markets and survive the inherent volatility.

5. Lean toward indexed investing. Select funds with low expense ratios based on an index that follows the asset class you are investing in. Even using index funds, you may end up with a few dozen funds, but each should provide a low-cost way of investing in that asset class.

Low-expense passive index investing has been receiving a growing percentage of investment dollars. This suggests that investor overconfidence in beating the market is decreasing. Investors have learned that just achieving a good market return is sufficient to achieve their goals.

Self-diagnosing investment overconfidence is nearly impossible. It's safe to say that if you are invested as much as you should be, you are likely overconfident. You are probably losing a few percentage points to this overconfidence, but because you aren't keeping track of your time-weighted return, you remain blissfully unaware.

A quarterly review of your portfolio for the five rules of investment humility just described can help you avoid a world of hurt. Brokers and agents don't have a fiduciary duty to act in your best interest. Visit the National Association of Personal Financial Advisors (www.napfa.org) to find a fee-only advisor in your area.

from http://www.emarotta.com/article.php?ID=295