Part 3 of Our Ongoing Saga About Risk, Which Is Fortunately A Trilogy

Here’s Part II. No, wait: Here’s Part I. Read those first, there’ll be an open-book quiz.

We’re explaining what all these mutual fund risk measurements mean. Yes, you want to know how much your mutual fund has gained and might likely gain, but the professionals have collectively decided that you need to know not only your fund’s propensity for gain, but how risky said fund is. Thus they applied some formulae to price swings, creating α, β, R², σ (that’s a lowercase sigma, the equivalent of the Roman letter S, the first letter in “standard deviation”), and two other quantities that are named after people with Anglo-Saxon names and thus aren’t symbolized with a Greek letter:

One more DODGX screenshot

Sharpe and Treynor ratios. What are they and do we care? Let’s answer the 1st question 1st.

William Sharpe is a 79-year-old Stanford professor and Nobel laureate. Decades ago, he tried to determine how much of a given investment’s returns are due to sagacity on the part of the investor, and how much are due to risk. If black 17 comes up and pays you 36-to-1, that means you’re 0% a shrewd roulette player, and 100% someone who benefitted from the inherent risk. The formula for the Sharpe ratio is relatively simple, so much so that it’s kind of amazing no one thought of it before the 1960s.

Start with the investment’s average rate of return, in this case over a 3-year period as indicated in the chart. Subtract the best available risk-free rate of return, like what you’d get from short-term government bonds – 10-year T-bonds, to be specific. Which, over the last few years, has been effectively zero. Then divide the difference by the standard deviation, which we explained Wednesday and which is a measure of how much monthly returns fluctuate with regard to the average. The theory goes that if you measure an investment by its excess return per unit of standard deviation, you’re focusing on how well the investment does on its own merits rather than how well it’s doing given its inherent risky nature.

The advantage of Sharpe ratio over α and β is that Sharpe ratio rates an investment on its own merits, rather than against a benchmark. The downside is that our denominator, standard deviation, can fluctuate for a host of reasons.

So what does a Sharpe ratio of 1.19 mean? Is it high, low? As always, it depends on the asset class. As you can read, Sharpe ratios in the Dodge & Cox Stock Fund’s asset class run around 1.12. DODGX beats the average by a few points, meaning that the data could be interpreted as evidence that DODGX’s managers are operating more on skill and less on luck than are their counterparts and competitors. T-bills have a Sharpe ratio of 0, and of course return less than T-bills’ means a negative Sharpe ratio. With time, as returns normalize, Sharpe ratios reduce. DODGX’s Sharpe ratio over the last 5 years is .59, and over the past decade .45.

Jack Treynor is a financial analyst with fewer academic credentials but almost certainly more money than William Sharpe. He developed his competing ratio a few years before Sharpe. Treynor ratio is identical to Sharpe ratio, except the former divides excess return (over T-bills) by β instead of by standard deviation. In other words, Treynor ratio measures returns with regard to market risk, instead of total risk. DODGX’s Treynor ratio is greater than the category’s Treynor ratio over the past 3 years. And the past 5 years, but not the past decade. Again, Treynor ratio compares returns with regard to volatility with respect to a benchmark. Neither Sharpe nor Treynor ratio has anything to say about how actively a fund or a portfolio is managed.

None of this is anything but mathematical masturbation. It’s dividing quantities by other quantities purely for the fun of it. As an investor, your objective is to make money. Not to beat benchmarks, nor to gauge your investments with regard to inherent and/or systemic risks. Most of the wealthiest people we know have no familiarity with any of these measurements, and wouldn’t see any reason for knowing how to calculate them.

You can choke on theory, or you can buy assets and sell liabilities. It really isn’t more complicated than that. The various risk measurements are nothing more than intellectual curiosities, the kind of stuff that the Nobel committee loves and that university business schools love even more. After all, it’s more material to add to the curriculum.

Furthermore, there’s a reason why every last piece of financial advice is punctuated with the following phrase: Past performance is not necessarily indicative of future results. α, β, R² etc. are incredibly helpful if you plan on traveling back in time and making investment decisions in the fall of 2010. In the market, there’s no better investment than a temporarily wounded stock. Until the academics learn how to quantify the implications of a Carnival Corporation ship capsizing or an iteration of Microsoft’s Windows 8 software being released with bugs, you’re better off looking for something undervalued and exercising patience.



What Makes A Lousy ETF

Putting your eggs in multiple baskets is the surest way to minimize risk and build wealth, right? You can add that to the list of homespun nonsense that sounds good but is patently false:

  • Wear a stupid wool hat, you lose 60% of your body heat through your head
  • The more you shave a particular body part, the faster the hair grows back
  • Standing in front of a microwave oven will bombard you with deadly gamma rays
  • Smoking is bad for you.

Behold the ETF (exchange-traded fund if you’re new here), a mutual fund that trades on a stock exchange. Like a mutual fund, it consists of the stocks of various companies, often numbering in the hundreds or even thousands. Unlike with a mutual fund, investors can buy and sell ETFs throughout the day. They have a ticker symbol and an immediately available price and everything. Mutual funds’ values aren’t calculated until the day closes and all their components’ prices have settled. Plus mutual funds don’t trade on exchanges, of course.

So what’s a good ETF to invest in? Let’s look atop the leaderboard. Never forget the 1st rule of investing, Past performance is a perfect predictor of future performance. 

(Kidding. The line about smoking was deathly serious, though.)

Your top 5 over the past year, regardless of market sector:


Screen Shot 2013-09-08 at 6.12.04 PM


Confused? Don’t be. The naming convention is standard: fund company, followed by description. Price is self-explanatory. That’s followed by performance since January 1 and performance since September 18 of last year.

Let’s take a look at the first one, iPath Long Extended Russell 1000 TR Index ETN. iPath isn’t a company, but rather a subsidiary of BlackRock. As for BlackRock, that’s an investment firm with a good reason for concealing its name. It’s owned by public charity case Bank of America, rate-fixing British bank Barclays, and PNC Financial Services (Pittsburgh National Corporation, the eponym of the Pirates’ ballpark.)

The ETF in question is actually an ETN, or exchange-traded note. The difference is that it’s composed of unsecured corporate notes, rather than stocks.

Extended Russell 1000 TR Index means that the ETN tracks the Russell 1000 Total Return Index. That’s an index composed of the prices of 1000 large firms that, according to Russell Investments, represent 92% of the U.S. market. As for Russell Investments, it’s a subsidiary of Northwestern Mutual, an insurance and financial services firm out of Milwaukee. And we are now 3 degrees removed from the subject at hand.

What about the worst fund in existence, defined as the one that’s lost the most money in the past year?


Behold NUGT, the too-clever stock symbol for the Direxion Daily Gold Miners Bull 3X Shares ETF. That’s a name with enough qualifiers that we should deconstruct it:

Direxion. Investment firm founded in 1997, based in Milwaukee. Or as their impregnable website copy puts it,

We offer practical investment solutions to today’s market challenges with a broad suite of highly liquid, institutional-style alternative investment strategies.

Well, that said nothing. What they mean is that the funds they sell are supposed to complement your investments, not be them.

“Institutional-style.” Here are some more empty buzzwords, all from a single “About” page:

  • risk-adjusted performance through evolving market conditions
  • position portfolios opportunistically for near- and long-term market trends
  • access to strategies that provide exposure to multidirectional opportunities
  • innovative investment products and services

Innovative? Don’t flatter yourself, Jim. The last “innovative investment product” was the hedge fund. You’re not creating the cotton gin or the mp3 player here.

No wonder most of our recent college graduates can’t find jobs. They can barely communicate.

Daily, in this instance, means that the fund sets daily goals for itself. That alone should be a clue for an individual investor to step back and be cautious. You’re in this for decades, remember? Who gives a damn what an ETF does from Tuesday to Wednesday? We’ll skip over the next couple of qualifiers, get back to them in a minute.

3x. The aforementioned daily goal is to outperform a particular index, and do so threefold. In other words, if the index rises 1% in a given day, the Direxion Daily Gold Miners Bull 3X Shares ETF should rise 3%.

Gold Miners. The index in question is not the Dow, nor even the S&P 500, but something considerably more specialized: the NYSE Arca Gold Miners index.

Do we need to break this down even more? We probably do. The New York Stock Exchange’s most famous index is, of course, the Dow Jones Industrial Average. But that’s just one among hundreds that the NYSE calculates. (Arca, by the way, is short for Archipelago Exchange – a Chicago-based electronic exchange that the NYSE’s parent company bought in 2005. We have to specify “electronic” because unlike NASDAQ and just about every other stock exchange on Earth, the NYSE still, incredibly, conducts much of its business via open outcry. That is, ill-tailored traders yelling at each other.)

The NYSE Gold Miners index is a constant multiplied by the total of the prices of the stocks of 29 gold mining companies, as follows:

index components


As you can see, the index isn’t close to evenly weighted. By the time you reach the bottom, the companies are small. Golden Star Resources, whose operations consist entirely of 2 mines in Ghana, has a market capitalization of about $140 million. That’s still one more mine than Nevsun has (in Eritrea.) Anyhow, the Gold Miners index changes daily and Direxion tries to beat the changes with this particular ETF.

Finally, Bull. Because there’s a corresponding Bear ETF that tries to do the exact inverse: achieve a daily return 3 times the opposite of the change in the Gold Miners index.

So there you go, with a definition that necessitated a long discussion. Now, onto the question that 99% of ETF owners never bother to ask:

What’s in my fund?

Well, that depends. Seeing as NUGT tries to take advantage of daily price fluctuations, its holdings change every day. Direxion’s own website offers no help on this issue, listing a useless summary of price movements in lieu of a comprehensive list of holdings. This is 2013, we’re better than this.

The good news is that Direxion won’t let you buy its daily funds unless you’ve proven that you’re rich and experienced. But this isn’t just an academic exercise. You owe it to yourself, almost literally, to find out what’s in your mutual funds. We’re teaching you to fish here. It takes just a minute or two. For instance, the T. Rowe Price Value Fund is the most widely held in the world. Regular investors just like you own pieces of it. Google the name of the fund, find its relevant page on the investment firm’s website, find out what it’s composed of, and stop complaining.

You Can’t Spell “Wealth” Without “O”

Every personal finance blogger's favorite baseball team

Every personal finance blogger’s favorite baseball team


Sports analogy time!

Adopting the logic of most people who dispense personal finance advice, the Kansas City Royals are the standard to which all other American League baseball teams should aspire. They’ve set an example that the rest of the league, indeed the rest of the world, can only look at with awe.


The standings don’t bear that out. The Royals have the 9th-best record in a 15-team league. They’re in 3rd place in the Central Division, 7 games back of Detroit. The Royals are also 4 1/2 games behind Texas in the wildcard race, with 4 other teams between them. They’re about as average and nondescript as a baseball team can be, all the way down to those godawful homosexual blue road uniforms that most major league teams had the good sense to get rid of in the ’80s.

Here’s what makes the Royals special: they’ve allowed only 555 runs, fewest in the league. In personal finance terms, they’ve incurred as few expenses as possible. The Royals are the baseball equivalent of the blogger who makes his own laundry detergent from leftover dish detergent and hand soap, leaves used wet paper towels in the sun to dry for reuse, drives across town because GasBuddy told him that a station 10 miles away is selling 87 octane for 4¢ a gallon cheaper than the station across the street, and makes his own dish detergent from leftover hand soap and laundry detergent.

What the overbearing voices of groupthink will tell you is that frugality – keeping the other team off the basepaths – is the only metric that matters. The fewer pennies you surrender, the happier and more fulfilling your life will be. Assuming, of course, that you enjoy denying yourself the pleasures that only spending money can bring. Yes, sunsets and the smiles on your kids’ faces are free and priceless. Great. If that’s all you need out of life, why are you looking at a computer screen right now?

There are two components to building wealth, and their relationship is every bit as symbiotic as that of the rhino and the tickbird. Your money can’t grow unless it exists in the first place (which is the lament of the frugality zealots.) Equally important is that you can’t just spend all your time amassing a modest pile of post-expenses cash and then trying your best to keep that pile from decomposing. Being adept at scoring runs gives you far more margin for both error and creativity on the other side of the ledger. The Boston Red Sox have a sense of proportion. They’ve allowed 8% more runs than the Royals have, putting Boston in the middle of the pack as far as defense goes. The Red Sox have also scored the most runs in the league, and not coincidentally have its best record. (The Royals are 11th in the league in scoring.) Offense without defense is useless, and vice versa.

You gotta make money, and holding yard sales isn’t going to cut it. So what’s the quickest and most efficient way around that conundrum? You could make yourself more valuable at your place of employment, but a) we can’t help you with that and 2) your employer will still be profiting off your hide. Instead, you have to learn how to leverage: how to defer current rewards for larger rewards down the road, ones that are positively disproportionate to the time elapsed. You need to know the difference between an IRA and a 401(k). And between a Roth and a traditional version of each. What a mutual fund is, and why it’s not a choice between investing in a mutual fund or a 401(k), etc. Learning about investment vehicles might not sound all that gripping to you. It might not be, and almost certainly isn’t, what your formal education focused on. Consider basic financial knowledge to be part of the price of being a functioning and productive member of society.

You know the rudiments of physical health, right? Smoking bad, grilled salmon good, sitting on the couch bad, riding a bike good etc. You didn’t need a degree in dietetics to comprehend that. Similarly, you don’t need a CPA designation to understand how tax brackets work and what the difference between credits and deductions is. We’re leading to yet another plug to buy our book here, but that’s not the primary purpose of this. Rather, we’re beseeching you to stop being fanatical about saving as much money as possible. Per hour committed to the task, it’s far more efficient and beneficial to look for ways to increase your existing stock of wealth than to look for ways to cut spending a little more. No worse advice has ever made it into axiomatic form than “A penny saved is a penny earned.” Nonsense. Once you start building a positive net worth, earning pennies becomes far easier than saving them. Also, the opportunities to earn greatly outpace the opportunities to save. You can only save so much. Your powers of accumulation are greater than that, and probably greater than you can imagine.

Or as we say over and over again, buy assets and sell liabilities. $7 spent on our book beats $7 saved by making your own toothpaste and placing the proceeds in a jar. Even if you’re saving orders of magnitude more than that, you can still do even more by buying assets. $2000 in an index fund beats $2000 negotiated off the price of a car. The former is dynamic, the latter static.

Now excuse as we hit you with the hard truth. The post up to this point was written for the benefit of those who aren’t carrying consumer debt. If you have a credit card balance or outstanding student loans, forget everything we said. Different, more spartan rules apply to those with a negative net worth. If you’re below zero, that’s where (and only where) the frugality kooks have a point. Do everything in your power to pay off those debts. Wear cheap clothes. Amuse yourself. Don’t be an idiot and plan a $20,000 wedding. You can’t build anything until your net worth starts with a +, however unassuming that number might be. Having a little bit of money puts you on a different and better continuum than the one the indebted are on. A failure to grasp that is why almost all poor people stay poor.