MONEY Taxes

What Happened When I Did My Taxes With My 10-Year-Old

What I learned about my kid—and what she learned about money—when we filled out the Form 1040 together.

This past weekend, I asked my 10-year-old daughter Lucy to help me do our family’s taxes. She read off from my W-2 and our 1099 forms as I filled in the boxes on the tax prep website we use. This meant, of course, that she got to see exactly how much her parents earn.

I expected that this was going to feel like the Big Reveal of a closely guarded secret. As I probably should have known, the numbers at first meant nothing to her. Annual incomes are an abstraction to a kid who has never written a rent check.

The real talk came a couple of days later, when Lucy and I had a chance to look over the actual 1040 I sent to the IRS, and I could show her how it all fit together. I’m glad we did that.

Before I get that to that conversation, though, a word about why I decided to do this. I was inspired in part by New York Times columnist Ron Lieber’s case for telling your children what you make. As Lieber points out, kids have a knack for figuring this out anyway. And showing them how you handle money—even when (believe me) you are far from perfect at it—can be a first step toward showing them how to be competent with it themselves.

I was also motivated by a more cranky-old-man impulse: I’ve been surprised by the number of young adults I meet who don’t know how to do their own taxes. To me, knowing how to fill out a 1040 is a just a basic life skill everyone should have by 18. I know this is more sentimental then reality-based. After all, I also put driving a stick shift in this category. And for years I’ve been farming out the hard work of my own taxes to the H&R Block website. (Thanks, AMT.)

Still, I remember that I was in the eighth grade, our teacher Sister Loretta had students fill out 1040s using mock W-2s as a math exercise. She was cracking the door on the adult world a little bit wider. Kids are always eager for those peeks, and when they get one, they seem especially open to learning. And talking.

For me and Lucy, the tax talk turned into one of the most impressively grown-up discussions we’ve ever had. She saw what we make, and I tried to put that in the context of what other Americans earn. She also saw what we pay, and so then we turned to where that money goes and what it’s used for. I tied the conversation in to a news story I read that day, about legislation in Kansas that would bar families on public assistance from spending that money on a long list things, including casinos, but also movie tickets and trips to the swimming pool. We talked about why some families need financial help, and why people have such strong opinions about that.

Lucy doesn’t need me sharing her nascent political views with the world, so I’ll just say that she surprised me (the way kids do) with her insights about what’s fair and about the choices people should have. Her ideas seemed too thought-out for her to just be parroting back what she guessed I’d like to hear. So I learned something about my daughter. And my wife and I also had a chance to articulate some of the values we are trying to pass on to our kids.

Lucy also asked a simple but very good question about our own money: “So this is how much you made, but how much do you have?” The distinction between making money and actually having any is an important one, and these days in our family we are frankly doing better on the former than the latter. Turning from our income tax forms to our savings, I was able to at least hint at some of the tricky choices her mom and I are trying to juggle.

Lucy didn’t get a “wow” moment of understanding from this, but I think I laid the groundwork for future discussions of things we have to be realistic about. Like how we’ll pay for Lucy to go to college, and where she’ll be able to go. And why (to hit on a question that’s really on her mind) she still has to share a room with her little brother.

I was able to have this conversation from a standpoint of some comfort. For a lot of parents, opening up about money means talking about losing a job, or how they’re dealing with a foreclosure, or how they’re going to buy the groceries this week. Those are much tougher things to talk about. But starting from where we are, and knowing we’ll have some ups and downs in the future, I think I’m glad that for my daughter this part of real life is already a little less mysterious.

MONEY Economy

The Gloomy Economic Message Hidden in the Fed Statement

Despite hints of a rate hike, stocks and bonds rallied on the Fed's latest announcement. Here's the kinda depressing reason why.

For the uninitiated, here’s a primer on Fed-ology 101: When the economy looks stronger, the Federal Reserve will want to raise interest rates to curb inflation. And once the Fed’s benchmark rates go up, that’s generally bad for the price of bonds — and (indirectly) for stocks too.

But we aren’t in a 101 class right now.

On Wednesday, Fed chair Janet Yellen announced the latest Federal Open Market Committee decision on rates, and dropped the word “patient” from her statement. That’s a signal that the Fed could raise rates as early as June. In other words, it thinks the economy is healing from the Great Recession.

So what happened next? The stock and bond markets rallied. That’s partly because the market already expected the language change. But it may also be because traders hear the Fed suggesting something a bit unnerving about the economy.

Along with the statement on current rates, the Federal Reserve also releases a survey of where FOMC members expect rates to go in the future. They brought down their estimates for where short-term interest rates are headed next year, from a median of 2.5% to 1.875%. In other words, even if the economy is getting better, the definition of “better” is looking a little slower than previously thought.

This at least rhymes with, even if it does not confirm, a worry among some economists that the global economy could be at risk of something called “secular stagnation,” or a pokey “new normal.” In a new normal world, interest rates and inflation tend to be lower for longer, but long-term growth is subdued too.

Factors that might contribute to a long-run slowdown range from inequality (which dampens demand) to demographics (slowing the growth of the workforce) to technology (which could mean companies need fewer workers and less capital investment.) Economist Lawrence Summers, who put the phrase “secular stagnation” on the map, says that this is a risk to be guarded against, not a sure thing or even the most likely one. And “new normal” has been a bit of a fad among bullish bond investors, who of course may be overconfident in their prediction that rates will stay low.

That said, the Fed’s latest statement is a reminder that the global economy is still very wobbly.

MONEY Federal Reserve

If the Fed Is Worried About Wall Street Bubbles, Maybe It Should Regulate Wall Street

Foot of George Washington statue with view of NYSE in the background
Randy Duchaine—Alamy

The Fed ponders raising interest rates to tamp down on financial speculation, but tight money is not the only option.

The Federal Reserve and the bond market are in a weird place right now.

Many officials inside the central bank are anxious to start getting back to normal, and to move short-term interest rates off the near-zero they’ve been at since the financial crisis. But the bond market isn’t listening: Even knowing that the Fed wants to tighten, investors have piled into long-term bonds, holding the benchmark interest rate for 10-year debt at just 2%.

This could mean that the bond market thinks the Fed is just plain wrong in its increasingly upbeat assessments of the economy. Investors’ eagerness to park money in low-yielding but credit-safe Treasuries seems to indicate deep worries about the prospects for long-term growth, and little concern about inflation. But as the Wall Street Journal’s Jon Hilsenrath noted yesterday, some inside the Fed are considering another interpretation of low bond yields. Maybe foreign investors are just pumping up U.S. assets because troubles overseas make anything denominated in dollars more attractive. If that’s the case, the Fed should be worried about asset bubbles.

And so, counterintuitively, New York Federal Reserve president Bill Dudley has been arguing that low long-term bond yields may be a reason for the Fed to tighten short rates even faster — to prick any bubbles that might be forming. Dudley, in a December speech cited by Hilsenrath, draws a comparison to the mid-2000s:

During the 2004-07 period, the [Fed] tightened monetary policy nearly continuously, raising the federal funds rate from 1% to 5.25% in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened.

Easy mortgages, it hardly needs pointing out, did not work out so well.

But raising rates is the only way policymakers could respond to concerns about reckless borrowing. On Twitter, economist Adam Posen, a former member of the Monetary Policy Committee at the Bank of England (the U.K.’s version of the Fed), ticked off some other possibilities.

All of these things amount to greater scrutiny of and tighter controls on bank lending behavior. Such policies are known in central-banking jargon as “macroprudential” regulation. The Fed itself is a regulator of banks. And even in the parts of finance where the Fed doesn’t have direct regulatory authority, it has influence as part of an umbrella group of “stability” regulators created after the crisis. It can also sound loud warnings, asking Congress for more regulatory tools and better rules.

Confronted with the possibility of financial-sector bubbles, we seem to have two choices:

1) Raise interest rates until the economy cries “uncle” and no one wants to speculate anymore. Do it even if it’s taken years and years for the economy to get anywhere close to full employment, and even if wage growth is still sluggish.

2) Make sure banks don’t leverage themselves up too their eyeballs, that Wall Street doesn’t create AAA-rated derivatives on junk mortgages that no one understands, and that people don’t get loans they can never pay back.

If forced to choose, I suspect people in finance, who most certainly have the Fed’s ear on these things, prefer the blunt hammer of option #1 over option #2. They’ll moan about regulation, and question whether it’s even realistic. And frankly, the Fed often hasn’t done that job very well. Wall Street has some of the cleverest people in the world working 24/7—crack down on one crazy, risky scheme, and they’ll come up with a new one. It’s also not crazy to be skeptical of the idea that central bankers will be able to know a bubble when they see it.

But of course trying to prevent bubbles by raising rates and tightening money is a form of regulation, too. The immediate costs are spread out a lot more widely, to everyone looking for a job or hoping to get a raise. And if the Fed should be humble about its abilities as a Wall Street regulator, well… it doesn’t have such a great track record on predicting when the economy will be healthy, either. So maybe it shouldn’t be too quick on the interest-rate trigger when inflation is still very low, unless there’s real evidence of an asset bubble somewhere.

MONEY

The Fed Sees the Economy Getting Back to Normal. The Market’s Not So Sure.

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SAUL LOEB—AFP/Getty Images

Why bonds are rallying even as the Fed hints at tightening.

The Federal Reserve has been signalling that it is getting ready to raise short-term interest from near-0% later this year. It recently ended its purchases of bonds under the unconventional stimulus program known as quantitative easing. Read the front-page newspaper headlines, and it looks like the era of very low interest rates is coming to an end.

But the numbers on the market tickers are telling a different story. This week the yield on safe 10-year Treasury bonds, a benchmark for long-term interest rates, tumbled to below 2%. What gives? How is it that interest rates are going down when it looks like the Fed wants to raise them?

The answer, in part, is simple. The Fed doesn’t get to set interest rates on its own. Day-to-day market commentary make it sound like interest rates can be changed with the push of a button: Fed chair Janet Yellen and the rest of Federal Open Market Committee declare that rates shall rise, and then, boom, you get a better deal on CDs and have to pay more to refinance your house.

In fact, in normal times, the Fed only sets short-term rates. What happens to rates on loans maturing years down the road is determined by investors, and it all plays out in the moment-to-moment fluctuations of yields on the bond market. When demand for bonds is high, their prices go up and yields go down; yields rise when bond prices fall. Bond investors think a lot about Fed policy, but they also have their eyes on a host of other economic fundamentals that determine how much it should cost to borrow money.

“Fed policy matters a lot in the short term,” Ben Inker, co-head of asset allocation at the mutual fund manager GMO, recently told me. “It only matters in the long-term if they show themselves to be incompetent.”

Of course, these haven’t been normal times. With the quantitative easing program, the Fed had also been buying up longer-term Treasuries. Lots of people believed that this meant yields were artificially low, and would spike once it looked like QE was over. But the end of the Fed’s bond purchases hasn’t led to a spike in rates. It turns out investors still really want to hold long-term government bonds. “I think now what people are saying is maybe rates weren’t artificially low—maybe they were low for a reason,” said Inker.

Investors like to hold Treasury bonds when they don’t care for the alternatives, such as putting money into expanding their businesses or building new office buildings, houses, and factories. And they are happier to accept low rates when they don’t see much risk of the economy overheating and producing inflation. In short, the low long-term yield on bonds reflects the market’s fairly pessimistic outlook for growth in the long term.

The latest economic numbers from the U.S. are looking healthier lately. Unemployment has come down, and consumer confidence is up. Bond markets, however, are seeing a lot of bad news abroad, and perhaps are worrying that it will spill over to the U.S. In Europe, for example, very low inflation is threatening to turn into deflation—or falling prices—which may sound nice for consumers, but reflects weak demand and makes it harder for borrowers to settle their debts.

The weak global economy has also brought down yields on other government’s bonds—Germany is paying 0.5%—which make Treasuries look like a comparatively good deal. That’s another factor keeping demand for U.S. bonds high and yields low right now.

So here’s the picture: The Fed sees an economy that’s getting stronger, and is looking to raise short-term rates sometime this year to get ahead of the risk of inflation. But markets still see plenty to worry about. Those worries may include, as economist Brad Delong has pointed out, the risk that the Fed may slow down the recovery too soon.

MONEY bonds

Why Skimpy Bond Yields Are a Retirement Game Changer

farmer in field of bad crop
Adrian Sherratt—Alamy Is a long season of slow growth and low returns ahead?

A 10-year Treasury bond now pays less than 2%. That may make it harder to earn the returns you expect in your 401(k).

Yields on the benchmark 10-year Treasury slipped below 2% on Tuesday as bonds rallied. (Bond prices rise when yields, or interest rates, fall, and prices fall as rates rise.) Since the aftermath of the 2008 financial crisis, bond yields have bounced around near historic lows. That’s had many investors worried about what would happen to their fixed-income investments when the seemingly inevitable rise in bond interest rates finally arrives.

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But in fact, today’s low yields could present a long-term challenge to retirement-oriented savers, even if interest rates stay low, and even if bonds today aren’t overpriced. And investing mostly or entirely in equities won’t immunize you from the problems of investing during a low-return era.

What happens if bond yields rise. First, let’s consider what happens if the conventional wisdom is right, and bond yields do start to rise again. If you hold bonds in a mutual fund as part of, say, a 401(k) plan, the most important thing you can do is understand your risk when bond prices fall. A plain-vanilla, intermediate-term bond fund these days has a “duration” of about 5.5. That measure of interest-rate risk roughly means that if rates rose by one percentage point, the fund would fall 5.5% in value. (Your actual loss would be lower, since you’d still be getting paid interest on the bonds in the fund.)

A decline in the value of a fund that’s the safe part of your retirement portfolio could come as a shock, and for money you may need soon, a shorter-duration bond fund makes sense. But keep short-run bond fund losses in perspective: Over the longer run, a shift up in rates can also help make up for what you lost, and the current yield on bonds gives you a strong clue about what to expect.

Say you own a diversified bond fund. Assume the yield is about 2% when you buy it, and the fund’s average bond matures in seven years. According to numbers from Vanguard, a sudden two-point jump in rates—a huge spike—would cause the fund to lose about 8% in total. As its bonds paid out higher yields, however, your annualized return after seven years would still be likely to level off to just about 2%.

What happens if yields stay low. The real risk with bonds today, however, may not be losses in the short run. It’s that the returns will stay frustratingly low for a long time.

Ben Inker, co-head of asset allocation at GMO, a Boston fund manager, lays out two scenarios, one he calls “purgatory” and the other “hell.” In purgatory, rates are headed for a spike. Bond prices will fall, and stocks might too. But after that you pick up better yield and better returns.

In hell, interest rates stay low. Part of the reason it’s hell is why interest rates stay low: The economy never gets back to its pre-2008 strength. With low growth prospects, there’s less demand for capital, and many investors around the world are content to accept relatively low returns on cash and bonds.

Part of the reason yields have recently fallen below 2% is that bond investors still see some risk of this “secular stagnation” scenario.

Ironically, in hell, your bond investments don’t lose money, since there’s no big rate spike. And today’s stock prices, oddly, might make sense too. Here’s why: When the price of stocks is high relative to long-run past earnings, future returns tend to be lower. Today the P/E ratio for stocks is expensive at 27. (The average is 17.) So stock returns may be on the low side. You still may be willing to take that deal, however, if you are earning only 2% on your bonds.

That may help explain why stocks have recently shot up. But if so, that’s a one-time adjustment. Hell is not just a low-bond-yield world. It’s a low-total-return world.

That would be bad news for savers, especially younger ones who will be putting much of their money into the market in the future. In the hell scenario, a typical portfolio earns 3.4% after inflation instead of the 4.7% Inker assumes you’d have gotten in the past. “Let’s say you turned 25 in 2009 and started saving,” he says. “You end up accumulating 25% less by retirement.”

Inker stresses he doesn’t know which scenario we’re headed for. The one constant is that in neither are there lots of opportunities to make money with low risk. “This is a frustrating environment for us as investors,” admits Inker. “It is less clear what the right thing to do is than throughout almost the rest of history.” The trouble with bonds, it turns out, is bigger than unpalatable yields. And it’s the trouble with an economy that is taking a long time to find its true normal.

 

This story is adapted from “How 2% Explains the World,” in the 2015 Investor’s Guide in the January-Feburary issue of MONEY.

MONEY bonds

This Nobel Economist Spotted the Last Two Bubbles—Here’s What He Says About the Bond Boom

Economist Robert Shiller
Joe Pugliese Economist Robert Shiller

The economist who wrote about irrational exuberance in stocks and real estate says bonds don't look like a classic bubble. But they're no bargain.

This month, Yale economist Robert Shiller, who shared the Nobel Prize in economics in 2013, is publishing the third edition of his classic book Irrational Exuberance. Some might take this as an ominous sign. The first version came out in 2000, and it made the case that stock valuations looked awfully high, and that people seemed too optimistic about tech stocks. You know what happened next.

The second edition, published in 2005, had a new chapter about the unusually high price of real estate. You know what happened that time, too.

Now Shiller has added a new chapter on another asset class that has become historically expensive: bonds. Should we be freaking out?

Bond prices rise when yields fall, and on Tuesday the benchmark Treasury yield slid below 2% for the first time since October. The long-term average for longer-term bond interest rates is 4.6%. Rates have been low ever since the 2008 financials crisis—and since at least 2009, some market observers have called the bond market a bubble.

Shiller, however, resists applying the B-word to bonds. “It doesn’t clearly fit my definition of ‘bubble,’” he says. “It doesn’t seem to be enthusiastic. It doesn’t seem to be built on expectations of rapid increases in bond prices.” (Shiller spoke with Money in December.) In the unlikely event you meet anyone at the proverbial cocktail party talking about bond funds, he’s probably complaining about the lousy yields, not talking about the killing he expects to make.

Still … Shiller does point to one similarity between today’s low yields and past bubbly episodes. Bubbles are a result of a psychological feedback loop: As asset prices go up, people come up with stories to explain why, which helps push prices higher, reinforcing the story, and so on. In the tech boom the story was of a new era of dotcom-fueled growth. The rationalizations about housing prices centered on cheap mortgages and financial “innovations.”

With bonds, too, says Shiller, “there are theories that have been amplified by the price performance.”

The low-rate story driving bond prices, however, is a gloomy one. Investors seek the relative safety of bonds—especially sure-to-pay-back Treasuries—when they feel pessimistic about the economy and comfortable that inflation will be low.

Professional bond managers today can tick off a host of factors weighing down rates and propping up fixed-income prices. There’s inequality, which may be holding back spending. The risk of deflation (falling prices) in Europe and Asia. Bad demographic trends in developed economies. You can even add robots, says Shiller. “There’s a suggestion that computers are going to create a more unequal world, and that this is inhibiting people’s spending plans,” says Shiller. Instead consumers try to save more, bidding up the prices of assets.

The idea of an economy that never quite gets back to prosperity has been labeled “secular stagnation” and the “new normal”—the latter term popularized by Bill Gross, before he made his surprising turn away from Treasuries. (Gross recently left Pimco for Janus. Here is a 2010 interview with Money in which he discussed his “new normal” view. )

The “new normal” story is at least partly built into today’s bond prices. That means even if yields stay low, the strong return on bonds in recent years are unlikely to repeat. (As a rule of thumb, the current yield on a 10-year Treasury is also the total return you can expect over the next decade. So that suggests a slim 2% return.)

Shiller also points out that his research with Wharton economist Jeremy Siegel has shown that bond investors are pretty bad at anticipating inflation. Forget fever dreams of ′70s-style price hikes—a return to 3% inflation would render Treasuries a money loser in real terms. (Inflation is currently below 2%.) That doesn’t seem like such a high bar to clear. It’s what some economists think a healthy economy would look like.

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That said, the slow-growth, mild-inflation scenario remains compelling. The last long period when rates were this low, before World War II, was followed by a long climb upward—but that coincided with postwar expansion, Cold War defense spending, and the baby boom. Maybe that was the anomaly. (If secular stagnation turns out to be real, here’s what that might mean for investors.)

Low rates have probably been even more important, says Shiller, in driving up stock prices. With yields on bonds so meager, investors may have shifted money into stocks in hopes of getting a better return. In early versions of his new edition of Irrational Exuberance, Shiller described today’s bull market as the “post-subprime boom.”

“But I changed it at the last minute,” he says. Now Shiller calls this era “the new normal boom.”

This story is adapted from “How 2% Explains the World,” in the 2015 Investor’s Guide in the January-Feburary issue of MONEY.

MONEY investment strategies

Why Even “Proven” Investment Strategies Usually Fail

Monopoly money
Alamy—Alamy Beware investment strategies that haven't been tried with real money.

Anyone with a computer can find a stock picking strategy that would have worked in the past. The future is another story.

You probably know, because you’ve read the boilerplate disclaimer in mutual fund ads, that past performance of an investment strategy is no indicator of future results.

And yet, funnily enough, nearly everyone in the investment business cites past results, especially the good results. Evidence that an investment strategy actually worked is a powerful thing, even if one knows intellectually that yesterday’s winners are more often than not tomorrow’s losers. At the very least, it suggests that the strategy isn’t merely a swell theory—it’s been tested in the real world.

Except that sometimes you can’t take the “real world” part for granted.

Just before Christmas, an investment adviser called F-Squared Investments settled with the Securities and Exchange Commission, agreeing to pay the government $35 million. According to the SEC, F-Squared had touted to would-be clients an impressive record for its “AlphaSector” strategy of 135% cumulative returns from 2001 to 2008, compared with 28% in an S&P 500 index. Just two problems:

First, contrary to what some of F-Squared’s marketing materials said, the AlphaSector numbers for this period were based solely on a hypothetical “backtest,” and there was no real portfolio investing real dollars in the strategy. In other words, after the fact, F-Squared calculated how the strategy would have performed had someone had the foresight to implement it. Underscoring how abstract this was, the backtest record spliced together three sets of trading rules deployed (hypothetically) at different times. The third trading model, which was assumed to go into effect in 2008, was developed by someone who, the SEC noted in passing, would have been 14 years old at the beginning of the whole backtest period, in 2001. (The AlphaSector product was not launched until late 2008; its record since it went live is not in question.)

Second, even the hypothetical record was inflated, says the SEC. The F-Squared strategy was to trade in and out of exchange traded funds based on “signals” from changes in the prices of the ETFs. But F-Squared’s pre-2008 record incorrectly assumed the ETFs were bought or sold one week before those signals could possibly have flashed. The performance, says the SEC, “was based upon implementing signals to sell before price drops and to buy before price increases that had occurred a week earlier.” Not surprisingly, a more accurate version of even the hypothetical strategy would have earned only 38% cumulatively over about seven years, not 135%.

Call it a woulda, shoulda—but not coulda—track record.

Steve Gandel at Fortune has been following this story for some time and has the breakdown here on how it all happened. This kind of thing is (one hopes) an extreme case. But there’s still a broader lesson to draw from this tale.

Although it’s a no-no to say that a strategy is based on a real portfolio when it isn’t, there’s not a blanket rule against citing hypothetical backtest results. In fact, backtesting is a routine part of the money management business. Stock pickers use it to develop their pet theories. Finance professors publish papers showing how this or that trading strategy could have beaten the market. Index companies use backtests to construct and market new “smart” indexes which can then be tracked by ETFs. But even when everyone follows all the rules and discloses what they are doing, there’s growing evidence that you should be skeptical of backtested strategies.

Here’s why: In any large set of data—like, say, the history of the stock market—patterns will pop out. Some might point to something real. But a lot will just be random noise, destined to disappear as more time passes. According to Duke finance professor Campbell Harvey, the more you look, the more patterns, including spurious ones, you are bound to spot. (Harvey forwarded me this XKCD comic strip that elegantly explains the basic problem.) A lot of people in finance are combing through this data now. But if they haven’t yet had to commit real money to an idea, they can test pattern after pattern after pattern until they find the one that “works.” Plus, since they already know how history worked out—which stocks won, and which lost—they have a big head start in their search.

In truth, the problem doesn’t go away entirely even when real money is involved. With thousands of professional money managers trying their hands, you’d expect many to succeed brilliantly just by fluke. (Chance predicts that about 300 out of 10,000 managers would beat the market over five consecutive years, according to a calculation by Harvey and Yan Liu.)

So how do you sort out the random from the real? If you are considering a strategy based on historical data, ask yourself three questions:

1) Is there any reason besides the record to think this should work?

Robert Novy-Marx, a finance professor at the University of Rochester, has found that some patterns that seem to predict stock prices work better when Mars and Saturn are in conjunction, and that market manias and crashes may correlate with sunspots. His point being not that these are smart trading strategies, but that you should be very, very careful with what you try to do with statistical patterns.

There’s no good reason to think Mars affects stock prices, so you can safely ignore astrology when putting together your 401(k). Likewise, if someone tells you that, say, a stock that rises in value in the first week of January will also rise in value in the third week of October, you might want to get them to explain their theory of why that would be.

2) What’s stopping other investors from doing this?

If there’s a pattern in stock prices that helps predict returns, other investors should be able to spot it. (Especially once the idea has been publicized.) And once they do, the advantage is very likely to go away. Investors will buy the stocks that ought to do well, driving up their price and reducing future returns. Or investors will sell the stocks that are supposed to do poorly, turning them into bargains.

That doesn’t mean all patterns are meaningless. For example, Yale economist Robert Shiller has found that the stock market tends to do poorly after prices become very high relative to past earnings. It may be that prices get too high in part because fund managers risk losing their jobs if they refuse to ride a bull market. Then again, the same forces that affect fund managers will probably affect you too. Will you being willing to stay out of the market and accept low returns while your friends and neighbors are boasting of double-digit gains?

And even Shiller’s pattern doesn’t work all the time—stock prices can stay high for years before they come down. Betting that you can see something that’s invisible to everyone else in the market is a risky proposition.

3) Does it work well enough to justify the expense?

Lots of strategies that look good on paper fade once you figure in real-world trading costs and management fees. A mutual fund based on the AlphaSector strategy, by the way, charges about 1.6% per year for its A-class shares. That’s eight times what you’d pay for a plain-vanilla index fund, which is all but certain to deliver the market’s return, minus that sliver of costs. And there’s nothing hypothetical about that.

MONEY

Most Financial Research Is Probably Wrong, Say Financial Researchers

Throwing crumpled paper in wastebasket
Southern Stock—Getty Images

And if that's right, the problem isn't just academic. It means you are probably paying too much for your mutual funds.

In the 1990s, when I first stated writing about investing, the stars of the show on Wall Street were mutual fund managers. Now more investors know fund managers add costs without consistently beating the market. So humans picking stocks by hand are out, and quantitative systems are in.

The hot new mutual funds and exchange-traded funds are scientific—or at least, science-y. Sales materials come with dense footnotes, reference mysterious four- and five-factor models and Greek-letter statistical measures like “beta,” and name-drop professors at Yale, MIT and Chicago. The funds are often built on academic research showing that if you consistently favor a particular kind of stock—say, small companies, or less volatile ones—you can expect better long-run performance.

As I wrote earlier this year, some academic quants even think they’ve found stock-return patterns that can help explain why Warren Buffett has done so spectacularly well.

But there’s also new research that bluntly argues that most such studies are probably wrong. If you invest in anything other than a plain-vanilla index fund, this should rattle you a bit.

Financial economists Campbell Harvey, Yan Liu, and Heqing Zhu, in a working paper posted this week by the National Bureau of Economic Research, count up the economic studies claiming to have discovered a clue that could have helped predict the asset returns. Given how hard it is supposed to be to get an edge on the market, the sheer number is astounding: The economists list over 300 discoveries, over 200 of which came out in the past decade alone. And this is an incomplete list, focused on publications appearing in top journals or written by respected academics. Harvey, Liu, and Zhu weren’t going after a bunch of junk studies.

So how can they say so many of these findings are likely to be false?

To be clear, the paper doesn’t go through 300 articles and find mistakes. Instead, it argues that, statistically speaking, the high number of studies is itself a good reason to be more suspicious of any one them. This is a little mind-bending—more research is good, right?—but it helps to start with a simple fact: There’s always some randomness in the world. Whether you are running a scientific lab study or looking at reams of data about past market returns, some of the correlations and patterns you’ll see are just going to be the result of luck, not a real effect. Here’s a very simple example of a spurious pattern from my Buffett story: You could have beaten the market since 1993 just by buying stocks with tickers beginning with the letters W, A, R, R, E, and N.

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Researchers try to clean this up by setting a high bar for the statistical significance of their findings. So, for example, they may decide only to accept as true a result that’s so strong there’s only a 5% or smaller chance it could happen randomly.

As Harvey and Liu explain in another paper (and one that’s easier for a layperson to follow), that’s fine if you are just asking one question about one set of data. But if you keep going back again and again with new tests, you increase your chances of turning up a random result. So maybe first you look to see if stocks of a given size outperform, then at stocks with a certain price relative to earnings, or price to asset value, or price compared to the previous month’s price… and so on, and so on. The more you look, the more likely you are to find something, whether or not there’s anything there.

There are huge financial and career incentives to find an edge in the stock market, and cheap computing and bigger databases have made it easy to go hunting, so people are running a lot of tests now. Given that, Harvery, Liu, and Zhu argue we have to set a higher statistical bar to believe that a pattern that pops up in stock returns is evidence of something real. Do that, and the evidence for some popular research-based strategies—including investing in small-cap stocks—doesn’t look as strong anymore. Some others, like one form of value investing, still pass the stricter standard. But the problem is likely worse than it looks. The long list of experiments the economists are looking at here is just what’s seen the light of day. Who knows how many tests were done that didn’t get published, because they didn’t show interesting results?

These “multiple-testing” and “publication-bias” problems aren’t just in finance. They’re worrying people who look at medical research. And those TED-talk-ready psychology studies. And the way government and businesses are trying to harness insights from “Big Data.”

If you’re an investor, the first takeaway is obviously to be more skeptical of fund companies bearing academic studies. But it also bolsters the case against the old-fashioned, non-quant fund managers. Think of each person running a mutual fund as performing a test of one rough hypothesis about how to predict stock returns. Now consider that there are about 10,000 mutual funds. Given those numbers, write Campbell and Liu, “if managers were randomly choosing strategies, you would expect at least 300 of them to have five consecutive years of outperformance.” So even when you see a fund manager with an impressively consistent record, you may be seeing luck, not skill or insight.

And if you buy funds that have already had lucky strategies, you’ll likely find that you got in just in time for luck to run out.

MONEY Apple

Here’s What Happened When We Tried Apple Pay

Sure, the new payment system looks all shiny in Apple's demos, but does it really work on the streets of New York? We set off to find out.

Updated at 9:30 pm

We gave Apple Pay a real-world test run on Monday, the day the new payment system launched. And as you can see in the video, it worked pretty well. At least where we already expected it to work.

There are a few wrinkles you don’t see on camera. Setting it up wasn’t quite seamless. I deliberately tried to set it up on my new iPhone without reading in advance about how to do it—after all, that’s how most people use their iPhones in real life. I found myself roadblocked pretty quickly. The Passbook app where credit card info is supposed to be stored… didn’t seem to have any way to enter my credit card info. It turned out I had to update my phone to the latest version of iOS 8. I got the phone just last week, and have already upgraded once, so that was a bit of surprise.

Day two (Tuesday) of trying to use Apple Pay in everyday life, with no camera crew around, was less successful. At Starbucks, I watched other customers paying with smartphone apps, but learned that they were using the coffee company’s own system. Starbucks doesn’t do Apple Pay. At a Duane Reade drugstore—a New York brand of Walgreens—the reader didn’t work. But the cashier told me most of the other readers in the store did. Later on, I successfully paid for a couple of Lightning cables at a Walgreens in Brooklyn. “Wait, that thing actually works?” said the woman behind the register.

Apple Pay doesn’t feel revolutionary. You take out your phone instead of your credit card to pay for things—it just means reaching into a different pocket. But that probably counts as a success for Apple in the long run. Using Apple Pay is similar enough to what I already do that I can see it easily creeping into my everyday routine.

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