Notice that I added a new column at the end for the weighted average return for all ten asset classes (assuming a ten percent stake in each asset class rebalanced monthly).

As you can see, June wasn’t a good month (click on the graphic to view a PDF version).

NOTE: I discovered a transposing error in last month’s numbers. I have made the correction on this month’s numbers.

…according to Vanguard: In four out of seven bear markets since January 1973, the Dow Jones U.S. Total Stock Market Index beat the average actively managed fund. The two bears in which many funds did better than the index were both in the 1980s.

This graphic included in the article doesn’t do much for the active management side of the argument (the graphic is slightly confusing because it doesn’t make clear that the bars represent the percentage of active managers that beat the Dow Jones U.S. Total Stock Market Index. You may click on the graphic to see a larger version):

This is all stuff we already knew but it’s interesting to read about it in a financial planning magazine.

Next, I’ll look at the performance of the indexes vs. their growth and value sub-indexes. Stay tuned…

As you can see, the results looks pretty good—especially when you consider the fact that one-third of the portfolio is in bonds and cash. Dr. Israelsen gives much more detailed information in his book, which I reviewed here. I was also able to conduct an interview with Dr. Israelsen. I’m going to keep tracking this portfolio. I’ll rebalance back to the orginal allocation and post updates monthly or quarterly (as time permits).

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NOTES: This portfolio assumes $1,000,000 initial investment with a 5% income withdrawal on December 31, 2009 for a net investment of $950,000. The portfolio also does not include trading costs.

The Vanguard REIT Index ETF is up over 24% year-to-date and now makes up 9.49% of the total portfolio.

I’ll have an update for the “7 Twelve” portfolio today.

I want to focus on his trick #2 – “average annual” return. According to Roth:

If you actually possess the attention span to slog through the 373 page disclosure document, you would clearly see on page 189 that the term “average annual return” is defined as 1/12 of the first month plus 1/12 of the second month, etc. This translates to getting an expected tad over half the total annual return. Depending on the timing of the market increase, this could be either more or less than half. In this example, it yields about 54% of the total increase of the index.

I asked Allan for clarification on exactly how this works and this is what he said:

“You’d have to use 1/12 of the YTD returns. The 12th month would count the full year’s return but it would only weight 1/12 of the amount.”

Allan did not provide me with the name of this particular annuity so I don’t know all the details. He did, however, tell me that this particular EIA will not allow the account to have a negative return over the year. It’s important to note that this is over the year and not on a month-to-month basis.

In order to see how this would work in the real world, I used the 2009 monthly returns for the S&P 500 Index (NOTE: These are index returns and NOT total returns, which would include dividends). Here is what I found:

In case it’s not clear, the YTD column is what’s used to calculate how the account is credited. Each of the months are credited 1/12th of whatever the YTD return is on the index. Then, those amounts are summed to get the return for the year. So, for 2009, while the index returned 23.45% (not including dividends), this annuity was credited with a 5.01% return (BEFORE FEES!). If you take off the 2% for fees, the return is down to around 3.01%.

Who in the world would go for such a product? Clearly this particular product favors the insurance company. They get the dividends and the 2% management expense. If the insurance company invests in the underlying index, they get the spread in returns (23.45 – 5.01).

I would avoid these products. They are complicated and very different so that it’s very hard to make an apples-to-apples comparison. I would stick to a fixed immediate annuity or possibly a very low cost variable annuity. If you are enticed by a an equity-index sales pitch, do yourself a favor and get a second opinion BEFORE you sign any documents.

Steve: I just bought a 1,000 shares of Intel.

Sherman: Why did you buy Intel?

Steve: I became interest when I heard a fund manager on CNBC yesterday recommend the stock. He gave a solid explanation for the purchase. So I went home and did my own research. I don’t just rely on the recommendations of others. What I found was that the company has a stream of new products in the pipeline that are expected to drive the growth in earning to a much higher rate. In addition, they have worked off the excess inventories that had developed. The stock, relative to the market, is also trading at a P/E multiple that is below its historic relationship. And, finally, the company’s balance sheet is very strong. This is a great company that had some hard times, but it’s poised for a turnaround.

Sherman: Those facts sound like good reason for buying the stock. However, in the end, the only logical reason for your purchasing that particular stock was that you believed that it would outperform the market. This must be so because owning just that one stock is taking more risk, because of the lack of diversification, than if you had purchased a total stock market index fund. Isn’t this correct?

Steve: I guess that is so, if you look at it that way.

Sherman: But that is the only way to look at it. At least the only correct way. Now, Steve, where did you get those shares?

Steve: I bought them through a brokerage firm, of course.

Sherman: That is not what I meant. What I meant was, from where did the shares you purchased come? They did not come out of thin air. Someone had to sell them to you. We can break up the market into two types of investors, individuals like you and me and institutional investors like pension funds, mutual funds, and hedge funds. Do you believe that the seller was more likely to be another individual investor like you? Or was the seller more likely to be one of those institutional investor I mentioned?

Steve: I would guess that the seller was another individual investor.

Sherman: That is incorrect. Since institutional investors do as much as 90 percent of all trading, there is as much as a 90 percent chance that the seller was an institution. Since we no agree that while the underlying reason you bought the stock was that you believed that it would outperform the market, we can also agree that the underlying reason that the institutional investor sold the stock was because it believed it would underperform the market. If this were not the case, the investor would have continued to hold that stock. Correct?

Steve: I guess so.

Sherman: Okay. So you believed it would outperform the market and the institutional investor believed it would underperform. How many of you can be correct?

Steve: Just one.

Sherman: Being perfectly honest with yourself, who do you believe had more knowledge about the company, you or the institutional investor?

Steve: I would have to say the institutional investor.

Sherman: I agree. Thus, all the reasons you gave me for buying Intel were also known by the institutional investor. What you thought was knowledge was really nothing more than information that other, more sophisticated investor also had. Yet they decided to sell the stock. So the logical question is: Why did you buy the stock knowing that there could only be one winner in the trade and you were likely to be the loser?

Steve: I never thought of it that way.

Sherman: Again, that is the only way to think about it. You are playing a game where there4 can only be one winner and you are playing that game with a competitive disadvantage. The most likely way to avoid losing that type of game is to not play. Consider the following. What I believe is the most interesting part of this game of trying to beat the market lies in the answer to this question: Who is the likely seller when one institutional investor buys? Is it an individual investor or another institution?

Steve: Well, since institutions do as much as 90 percent of the trading, the logical answer must be that when one institution is buying, the seller is likely to be another institutional investor.

Sherman: Correct. One institution bought, say, one of Merrill Lynch’s mutual funds, because it thought it would outperform, while the other institution sold, say, one of Morgan Stanley’s mutual funds, because it thought Morgan Stanley would underperform. How many of them can be right?

Steve: Obviously, only one.

Sherman: Now, how many of them are spending your money, in the form of the operating expense ratio, commissions, and other trading costs in the effort to outperform the market?

Steve: Both of them are.

Sherman: This is why active management is a loser’s game. Since outperforming the market must be a zero-sum game before the expenses of the effort, in aggregate, after expenses, it must be a loser’s game for investors. Collectively, active investors must underperform the market by the total of all of their expenses. And since most of the competition is between very sophisticated institutional investors to find enough victims, meaning people like you and me, to exploit in order for them to overcome the hurdle of their expenses. So, Steve, with your newfound insight, would you still have done that trade?

Steve: I see why it really doesn’t make sense. I see that it is likely that I will only “discover” information that these institutional investors already know. Therefore, that information is already built into the current price.

Sherman: Now you see why I never buy any individual stocks. I don’t like playing a game where the odds are stacked against me. And, more important, I have far more important things to do with my time than doing research on stocks—like spending time with my family.

Steve: Well, I know my wife would agree with you on that.

Notice Swedroe is not saying that some stocks can’t be undervalued. Rather, he is saying that they are hard to find. One thing he doesn’t mention is that sometimes mutual funds are forced to sell stocks due to redemptions. So, they may like a particular stock but have to sell it in order to meet investor redemptions. I do think that with the invention of the computer and the internet, it is a lot more difficult to find undervalued stocks.

Anyway, I thought this conversation was interesting. Thoughts?

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Earlier this year, when stocks were on the mend and investors were less anxious, the correlation between the S&P 500 and its stocks fell below 50%, suggesting investors were looking for individual stocks to own rather than just buying large indexes.

But by mid-June, the correlation had jumped back above 70%, as investors stopped looking for winners and just sold broadly. Last week it surpassed its 2008 high of 79% and hit 81%, the highest level since the 1987 crash, when it touched 83% for one day. That means that on most days recently, the great majority of stocks in the S&P 500 were moving in the same direction, up or down.

This is causing headaches for stock pickers and those who normally flee to dividend-paying stocks in volatile times.

The reason for this high correlation?

According to the article, correlation normally runs higher during volatile times but it’s also due to the increasing popularity of index funds and exchange-traded funds, which trade the all the stocks in the index. The article mentions that dividend-paying stocks are being held down and risky stocks (technology) are being propped up.

Two sides to the coin.

Indexers will use this as another example of just how hard it is to pick stocks, while stock pickers will claim that certain stocks are now undervalued. In other words, nothing’s changed.