MONEY Warren Buffett

The 6 Most Important Quotes From Warren Buffett’s Greatest Shareholder Letter Ever

Warren Buffett
Nati Harnik—AP

Why did Berkshire under Buffett do so well?

Last week, Berkshire Hathaway BRK 0% released its 2014 shareholder letter. Warren Buffett’s letter, always closely followed, was particularly anticipated this year. Indeed, as this year will mark a half-century of Berkshire Hathaway under “current management,” Buffett had promised two “looking back/looking forward” analyses, one from his pen and one from that of his partner, Berkshire Vice Chairman Charlie Munger.

Here are some of the key quotes from this year’s letter. (I’ve identified those that come from Munger.)

Buffett’s successor: one of two men?

With Buffett now 84, Berkshire’s succession plan is a matter of intense speculation. His latest comments on the matter (my emphasis):

Our directors believe that our future CEOs should come from internal candidates whom the Berkshire board has grown to know well. Our directors also believe that an incoming CEO should be relatively young, so that he or she can have a long run in the job. Berkshire will operate best if its CEOs average well over 10 years at the helm. (It’s hard to teach a new dog old tricks.) And they are not likely to retire at 65 either (or have you noticed?). … Both the board and I believe we now have the right person to succeed me as CEO — a successor ready to assume the job the day after I die or step down. In certain important respects, this person will do a better job than I am doing.

Who might the successor be? Munger offers a clue that appears to narrow it down to two individuals (my emphasis):

But under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.” For instance, Ajit Jain and Greg Abel are proven performers who would probably be under-described as “world-class.” “World-leading” would be the description I would choose. In some important ways, each is a better business executive than Buffett.

Berkshire Hathaway Reinsurance head Ajit Jain is 63, and Berkshire Hathaway Energy CEOGreg Abel is 52. In terms of age and expected tenure, Abel has the advantage.

The timing of the elusive Berkshire dividend

Another recurring debate in the financial media is the value and timing of a potential Berkshire dividend — although, as we shall see, it’s not much of a debate among shareholders. Buffett provides his first time-bound guidelines:

Eventually — probably between 10 and 20 years from now — Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases, or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.

That doesn’t appear to be a problem for current shareholders:

Nevertheless [in response to last year’s proxy motion requesting a dividend], 98% of the shares voting said, in effect, “Don’t send us a dividend but instead reinvest all of the earnings.” To have our fellow owners — large and small — be so in sync with our managerial philosophy is both remarkable and rewarding. I am a lucky fellow to have you as partners.

Munger’s contribution to Berkshire

Although he has remained in Buffett’s shadow over the past 50 years, it’s almost impossible to overstate Munger’s contribution to Berkshire Hathaway. Buffett pays tribute to it:

From my perspective, though, Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices. … Charlie never tired of repeating his maxims about business and investing to me, and his logic was irrefutable. Consequently, Berkshire has been built to Charlie’s blueprint. My role has been that of general contractor, with the CEOs of Berkshire’s subsidiaries doing the real work as sub-contractors.

The 4 keys to Berkshire’s success

Munger returns Buffett’s compliment:

Why did Berkshire under Buffett do so well?

Only four large factors occur to me: (1) the constructive peculiarities of Buffett, (2) the constructive peculiarities of the Berkshire system, (3) good luck, and (4) the weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press.

I believe all four factors were present and helpful. But the heavy freight was carried by the constructive peculiarities, the weird devotion, and their interactions. In particular, Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis.

Buffett was, in effect, using the winning method of the famous basketball coach John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players. That way, opponents always faced his best players, instead of his second best. And, with the extra playing time, the best players improved more than was normal.

And Buffett much out-Woodened Wooden, because in his case the exercise of skill was concentrated in one person, not seven, and his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player does.

The Berkshire system: 15 rules for building a world-leading conglomerate

What is this “Berkshire system” Munger refers to, which has been at the core of Berkshire’s unparalleled success? He codifies it in 15 points:

The management system and policies of Berkshire under Buffett (herein together called “the Berkshire system”) were fixed early and are described below:

(1) Berkshire would be a diffuse conglomerate, averse only to activities about which it could not make useful predictions.

(2) Its top company would do almost all business through separately incorporated subsidiaries whose CEOs would operate with very extreme autonomy.

(3) There would be almost nothing at conglomerate headquarters except a tiny office suite containing a chairman, a CFO, and a few assistants who mostly helped the CFO with auditing, internal control, etc.

(4) Berkshire subsidiaries would always prominently include casualty insurers. Those insurers as a group would be expected to produce, in due course, dependable underwriting gains while also producing substantial “float” (from unpaid insurance liabilities) for investment.

(5) There would be no significant systemwide personnel system, stock option system, other incentive system, retirement system, or the like, because the subsidiaries would have their own systems, often different.

(6) Berkshire’s chairman would reserve only a few activities for himself. […]

(7) New subsidiaries would usually be bought with cash, not newly issued stock.

(8) Berkshire would not pay dividends so long as more than one dollar of market value for shareholders was being created by each dollar of retained earnings.

(9) In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the chairman could pretty well understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters.

(10) In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness, skill, energy, and love for the business and circumstances the CEO was in.

(11) As an important matter of preferred conduct, Berkshire would almost never sell a subsidiary.

(12) Berkshire would almost never transfer a subsidiary’s CEO to another unrelated subsidiary.

(13) Berkshire would never force the CEO of a subsidiary to retire on account of mere age.

(14) Berkshire would have little debt outstanding as it tried to maintain (i) virtually perfect creditworthiness under all conditions and (ii) easy availability of cash and credit for deployment in times presenting unusual opportunities.

(15) Berkshire would always be user-friendly to a prospective seller of a large business. An offer of such a business would get prompt attention. No one but the chairman and one or two others at Berkshire would ever know about the offer if it did not lead to a transaction. And they would never tell outsiders about it.

Both the elements of the Berkshire system and their collected size are quite unusual. No other large corporation I know of has half of such elements in place.

The continued success of Berkshire after Buffett

Will the “Berkshire system” ensure continued success, despite its size, and after Buffett? Buffett says yes:

Despite our conservatism, I think we will be able every year to build the underlying per-share earning power of Berkshire. That does not mean operating earnings will increase each year — far from it. The U.S. economy will ebb and flow — though mostly flow — and when it weakens, so will our current earnings. But we will continue to achieve organic gains, make bolt-on acquisitions, and enter new fields. I believe, therefore, that Berkshire will annually add to its underlying earning power.

Munger concurs:

The next to last task on my list was: Predict whether abnormally good results would continue at Berkshire if Buffett were soon to depart. The answer is yes. Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage. Moreover, its railroad and utility subsidiaries now provide much desirable opportunity to invest large sums in new fixed assets. And many subsidiaries are now engaged in making wise “bolt-on” acquisitions.

Provided that most of the Berkshire system remains in place, the combined momentum and opportunity now present is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if (1) Buffett left tomorrow, (2) his successors were persons of only moderate ability, and (3) Berkshire never again purchased a large business.

These quotes provide some of the important lessons from this year’s letter, but the document is extraordinarily rich in business and investing lessons and will be analyzed and debated for years to come — including here on Fool.com. Be sure to check back in the next few days for more coverage of the 2014 Berkshire Hathaway shareholder letter.

MONEY Warren Buffett

The Guy Who Made a $1 Million Bet Against Warren Buffett

Warren Buffett
Nati Harnik—AP

Even if hedge funds were winning—which they aren't—you still should be in indexes.

Warren Buffett bet a prominent U.S. hedge fund manager in 2008 that an S&P 500 index fund would beat a portfolio of hedge funds over the next ten years. How’s it going?

“We’re doing quite poorly, as it turns out,” president of Protege Partners Ted Seides, who made the bet with Buffett, told Marketplace Morning Report today. In fact, an S&P 500 fund run by Vanguard rose more than 63%, while the other side of the wager, a portfolio of funds that only invest in hedge funds, has only returned 20% after fees.

The fees are the important component. When the two sides made their respective cases for why they would win, Buffett noted that active investors incur much higher expenses than index funds in their quest to outperform the market. These costs only increase with hedge funds, or a fund of hedge funds, thus stacking the deck even more in his favor.

“Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested,” Buffett argued at the time. “A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.”

Before fees, Seides’s picks would be up 44%—still almost twenty percentage points behind Buffett, but way ahead of where they are.

Seides, to his credit, has been transparent. “Standing seven years into a 10-year wager with Warren Buffett, we sure look wrong,” he wrote in a recent blog post for CFA Institute. He went on to cite the Federal Reserve, both for its decision to keep interest rates at basically zero and undertake an unconventional bond-buying program to jumpstart the economy in the wake of the Great Recession, as one reason why his portfolio has been so roundly beaten by the S&P 500. Of course, investors inability to consistently foresee and time major market events is one reason why index funds are so powerful. (He also points out that a broad stock market index fund is a poor measuring stick for hedge fund performance.)

There’s still three years left in the bet, but barring a prolonged stock market crash, Girls Incorporated of Omaha—Buffett’s charity of choice—seems well placed to win. (The size of that donation stands right now at more than $1.5 million, for reasons having to do with zero-coupon bonds.) Those who are inclined to support passive investing, like MONEY, can be satisfied that once again indexes trumped active traders.

Now here’s the thing: Seven years ago, Seides’ chances of winning this bet actually weren’t so terrible. Cheap index funds have a strong statistical edge over active managers, but that doesn’t mean every stock picker loses. Last December, S&P Dow Jones Indices published “The Persistence Scorecard,” which measures whether outperforming fund managers in one year can continue to outperform the market going forward. “Out of 681 funds that were in the top quartile as of September 2012, only 9.8% managed to stay in the top quartile at the end of September 2014,” according to the report. While that’s not a terribly good record, about 10% of portfolio managers (and their shareholders) think that they are clever investors.

The trouble is, they probably won’t be in the top 10% of investors over the next ten years. There will always be market beaters, even if just by random (and unfortunately unpredictable) chance. That fact goes a long way towards keeping money managers in business.

So when you hear a hot-shot alpha investor type say that he’s beaten the market over the last couple of years, just remember: Stuff happens.

MONEY Warren Buffett

Warren Buffett’s Secret to Staying Young: 5 Cokes a Day

150226_INV_WarrenBuffettCoke
Daniel Acker—Bloomberg via Getty Images Warren Buffett, chief executive officer of Berkshire Hathaway, drinks a Cherry Coca-Cola.

The world’s most successful investor stays youthful by eating "like a 6-year-old." Turns out, the Berkshire Hathaway CEO’s bizarre diet is highly strategic.

How does the world’s top investor, at 84 years old, wake up every day and face the world with boundless energy?

“I’m one quarter Coca-Cola,” Warren Buffett says.

When he told me this in a phone call yesterday (we were talking about the death of his friend, former Coca-Cola president Don Keough), I assumed he was talking about his stock portfolio.

No, Buffett explained, “If I eat 2700 calories a day, a quarter of that is Coca-Cola. I drink at least five 12-ounce servings. I do it everyday.”

Perhaps only a man who owns $16 billion in Coca-Cola KO 0.71% stock—9% of Coke, through his company, Berkshire Hathaway BRK.A -0.23% —would maintain such an odd daily diet. One 12-ounce can of Coke contains 140 calories. Typically, Buffett says, “I have three Cokes during the day and two at night.”

When he’s at his desk at Berkshire Hathaway headquarters in Omaha, he drinks regular Coke; at home, he treats himself to Cherry Coke.

“I’ll have one at breakfast,” he explains, noting that he loves to drink Coke with potato sticks. What brand of potato sticks? “I have a can right here,” he says. “U-T-Z” Utz is a Hanover, Pennsylvania-based snack maker. Buffett says that he’s talked to Utz management about potentially buying the company.

Investors in Berkshire Hathaway may feel relieved that the CEO isn’t addicted to Utz Potato Stix at every breakfast. “This morning, I had a bowl of chocolate chip ice cream,” Buffett says.

Asked to explain the high-sugar, high-salt diet that has somehow enabled him to remain seemingly healthy, Buffett replies: “I checked the actuarial tables, and the lowest death rate is among six-year-olds. So I decided to eat like a six-year-old.” The octogenarian adds, “It’s the safest course I can take.”

This article originally appeared on Fortune.com.

MONEY investing strategy

The Track Records of Wall Street’s Top Strategists Are Worse Than You Think

fever graph on screen
Richard Drew—AP

Listening to Wall Street's top strategists is no better than random guessing.

This is embarrassing.

There are 22 “chief market strategists” at Wall Street’s biggest banks and investment firms. They work at storied firms such as Goldman Sachs and Morgan Stanley. They have access to the best information, the smartest economists, and teams of brilliant analysts. They talk to the largest investors in the world. They work hard. They are paid lots of money.

One of their most important — and certainly highest-profile — jobs is forecasting what the stock market will do over the next year. Strategists do this every January by predicting where the S&P 500 will close on Dec. 31.

You won’t be shocked to learn their track record isn’t perfect. But you might be surprised at how disastrously bad it is. I certainly was.

On average, chief market strategists’ forecasts are worse than those made by a guy I call the Blind Forecaster. He’s a brainless idiot who assumes the market goes up 9% — its long-term historic average — every year, regardless of circumstances.

Here’s the average strategist’s forecast versus actual S&P 500 performance since 2000:

Some quick math shows the strategists’ forecasts were off by an average of 14.7 percentage points per year.

How about the Blind Forecaster? Assuming the market would rise 9% every year since 2000 provided a forecast that was off by an average of 14.1 percentage points per year.

Underperforming the Blind Forecaster isn’t due to 2008, which forecasters like to write off as an unforeseeable “black swan.” Excluding 2008, the strategists’ error rate is 12 percentage points per year, versus 11.6 percentage points per year for the Blind Forecaster. Our idiot still wins.

The Blind Forecaster wasn’t a good forecaster, mind you. He was terrible. He missed bear markets and underestimated bull markets. In only one of the last 14 years was his annual forecast reasonably close to being accurate. But he was still better than the combined effort of 22 of Wall Street’s brightest analysts.

And the Blind Forecaster required no million-dollar salary. He worked no late nights. He attended no conference calls, meetings, or luncheons. He made no PowerPoint presentations, and never appeared on CNBC. He has no beach house, and was granted no bonuses. He works free of charge, offering his services to anyone who will listen.

Amazingly, these stories aren’t rare. In 2007, economists Ron Alquist and Lutz Kilian looked atcrude futures, a market used to predict oil prices. These markets were actually less accurate at predicting oil prices than a naïve “no-change” forecast, which assumes the future price of oil is whatever the current price is now. The no-change forecast was terrible at predicting oil prices, of course. But it was better than the collective effort of the futures market.

This raises two questions: Why do people listen to strategists? And why are they so bad?

The first question is easy. I think there’s a burning desire to think of finance as a science like physics or engineering.

We want to think it can be measured cleanly, with precision, in ways that make sense. If you think finance is like physics, you assume there are smart people out there who can read the data, crunch the numbers, and tell us exactly where the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how bright the moon will be on the last day of the year.

But finance isn’t like physics. Or, to borrow an analogy from investor Dean Williams, it’s not like classical physics, which analyzes the world in clean, predictable, measurable ways. It’s more like quantum physics, which tells us that — at the particle level — the world works in messy, disorderly ways, and you can’t measure anything precisely because the act of measuring something will affect the thing you’re trying to measure (Heisenberg’s uncertainty principle). The belief that finance is something precise and measurable is why we listen to strategists. And I don’t think that will ever go away.

Finance is much closer to something like sociology. It’s barely a science, and driven by irrational, uninformed, emotional, vengeful, gullible, and hormonal human brains.

If you think of finance as being akin to physics when it’s actually closer to sociology, forecasting becomes a nightmare.The most important thing to know to accurately forecast future stock prices is what mood investors will be in in the future. Will people be optimistic, and willing to pay a high price for stocks? Or will they be bummed out, panicked about some crisis, pissed off at politicians, and not willing to pay much for stocks? You have to know that. It’s the most important variable when predicating future stock returns. And it’s unknowable. There is no way to predict what mood I’ll be in 12 months from now, because no matter what you measure today, I can ignore it a year from now. That’s why strategists have such a bad record.

Worse than a Blind Forecaster.

Check back every Tuesday and Friday for Morgan Housel’s columns.

The more you know about the most common mistakes that investors make, the better your likelihood of building lasting wealth. Click here for more commentary on how I think about investing and money.

Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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MONEY Tech

Why Apple Won’t Buy Tesla

Tesla Model S
Tesla Tesla Model S

It doesn't make any sense.

According to Jason Calacanis, who bills himself as an “angel investor, entrepreneur, conference host, and podcaster,” Apple APPLE INC. AAPL -0.14% will spend $75 billion to acquire Tesla Motors TESLA MOTORS INC. TSLA 1.62% within the next year-and-a-half. While he listed a number of reasons for such a deal, his primary argument is that “once the [Tesla] Model 3 hits the road, Tesla’s market cap would make a deal with Apple a merger — not an acquisition.”

In other words, Calacanis expects such a sharp upturn in Tesla financials once it launches the more affordable Model 3 car that its market capitalization could be well north of what even Apple could afford — assuming, of course, Apple even wants to buy Tesla.

But this seems highly implausible to me.

Tesla is already quite richly valued

The first fundamental flaw with this claim is the idea that Tesla financials and market capitalization will skyrocket once the company is delivering relatively affordable electric vehicles in significant volumes. I would argue the current $25 billion market capitalization already bakes in some pretty high investor expectations.

To put this into perspective, current analyst consensus for Ford 2015 revenue — keep in mind that Ford is already in the high-volume, mainstream automobile game — sits at $143.7 billion, and its market capitalization is just shy of $64 billion as of this writing. Tesla trades at approximately 39% of Ford’s market capitalization even though the upstart carmaker is projected to generate just 4% of its 2015 revenue.

Of course, Tesla is a much higher-growth company, and it is far “sexier” than Ford, so I do not take issue with Tesla getting a richer valuation. The problem, though, is that the stock price today — at least, from what I can tell — already bakes in a lot of future success.

That means when or if Tesla succeeds in driving more volume and growing its revenue significantly, the financials might improve, but I am not convinced this could lead to the huge growth in the stock price that Calacanis predicts.

Apple would be better off buying its own stock

If Apple were to drop $75 billion on Tesla today (a three times premium to the current market capitalization), it is highly questionable as to when the company could see a return on that investment. Tesla has outright stated it does not expect to be profitable on a GAAP basis until 2020.

In this scenario, not only would Apple have to wait five years before a single cent of profit showed up on the income statement, but Tesla operations could actually drag on Apple. If the company owns Tesla, and Tesla is losing money, then that comes straight out of Apple financials.

Additionally, since Apple would need to buy Tesla with U.S.-based cash or with stock, the deal would either force the tech giant to issue shares, undoing the benefits of previous stock repurchases, or to issue a hefty amount of debt, which means paying interest on that debt. Alternatively, Apple could repatriate its foreign-held cash and get hit with a huge tax bill, but that would probably be the least likely option.

If Apple is really itching to spend $75 billion on something, it would be far better for the company to simply buy back stock. At least in this case, Apple would shrink the number of shares outstanding, immediately providing a meaningful boost to earnings per share. In my humble view, that would certainly be a quicker and easier way to juice the bottom line than to spend an exorbitant amount of money on Tesla.

MONEY stocks

Can You Really Beat the Market?

Campbell Harvey, Professor of Finance at Duke's Fuqua School of Business
Jeff Brown Don't assume everything you read in financial journals is true, says Duke University finance professor Campbell Harvey.

Turns out the smart money isn't always so.

We put the question to Duke University finance professor Campbell Harvey, 56, former editor of the Journal of Finance and president-elect of the American Finance Association. Harvey is known for taking unorthodox positions when it comes to academic research, portfolio rebalancing, and Bitcoin.

MONEY writer Taylor Tepper interviewed Campbell for the March 2015 issue of the magazine, where this edited interview originally appeared.

Q: Can you really beat the market?

A: There’s all this academic research out there that attempts to explain why stocks do well or poorly by focusing on investment factors, such as momentum or low price/earnings ratios. In all, 316 different factors were identified in the papers I studied, including things like the amount of media attention a company gets or how much it spends on advertising. My research found that of all the published papers in finance, over half are likely false. The problem is the researchers were applying the tools of statistics as if there was only one test going on when there are multiple variables. Some factors are going to look statistically significant just by chance.

Q: Can you help us understand?

A: There’s a cartoon that explains this well. Let’s say somebody has a hypothesis that jelly beans cause acne. So researchers conduct a controlled experiment where some people get jelly beans and some don’t. It turns out that there’s no significant difference. Then somebody says, “Well, maybe we’re looking at this incorrectly. We should look at this by the color of the jelly bean. So then 20 new experiments are undertaken. Again, some people get jelly beans and others don’t. But the jelly beans are just red. A separate experiment uses just yellow beans. Then all purple. Each time there’s no effect. On the 20th try, which happens to test green jelly beans, they find there’s a difference that is statistically significant by the usual rules. And then in the newspaper the next day, there’s this headline: GREEN JELLY BEANS CAUSE ACNE.

Q: What should the standard be?

A: Usually you’re looking for 95% confidence, which means there’s a 5% chance the result was a fluke. But that’s true only if you’re conducting a single test. As soon as you go to multiple tests, it’s like the jelly bean problem. You do 20 experiments and you’re likely to get a hit by chance.

Q: To be fair, you’ve made this mistake yourself.

A: Some of the papers we analyzed are my own. This actually gives me a bit of a pass when I’m talking to my colleagues and saying, “Half of what you guys published is false.” And they kind of push back: “How could you say that?” And I say, “Well, it also holds for me, okay?”

Q: What does this mean for the average investor?

A: For individual investors the best thing to do is to just go with an index fund. Don’t believe these claims of using this or that “factor” to beat the market. Invest in the broad market, and go with the lowest possible fee.

Q: But so-called smart beta index funds claim to capitalize on these “factors.”

A: Imagine there are 316 of these “smart” beta index funds, each chasing one of the factors that I detail. It is likely that more than 50% of them are destined to disappoint.

Suppose there’s an ETF investing only in stocks beginning with the letter “H.” The managers claim historical outperformance for H stocks based on simulations going back to 1926. They claim their results are “significant.” They’re likely using the wrong statistical method to declare their strategy “true.” They might have tried 26 letters and “H” worked by chance.

“Don’t believe these claims of using this or that ‘factor’ to beat the market. Invest in the broad market, and go with the lowest possible fee.”The insight is the same for 316 factors. If you try enough strategies, some will work by luck. In many cases it’s not about being “smart.”

Q: Speaking of smart, rebalancing has been recommended as a prudent approach. You’ve done research on this topic, right?

A: Rebalancing is like mom-and-apple-pie sort of finance, in that we just assume it’s a good idea. We don’t think through what it involves. In my research I detail the risk that is induced by a rebalancing strategy.

Q: Don’t you rebalance to reduce risk?

A: Let’s say you’ve got a portfolio of 60% stocks and 40% bonds. Now, imagine stocks drop and you’re in a prolonged bear market. If you’re rebalancing, you have to buy equities to get that proportion back up to 60%. So as stocks are falling, you’re buying more and more. Your portfolio is going to have a bigger drawdown than another portfolio where you didn’t rebalance.

It works in bull markets too. If equities are going up and up and you’re rebalancing, you’re dumping stocks. The market goes up. You dump more. All of a sudden your portfolio has done worse than if you had just let it run.

Q: So how should investors think about rebalancing then?

A: It is not smart to rebalance the last day of the year or the last day of the quarter by rote. It means you’re ignoring all of the information in the market. There’s lots of information out there, so use that
information. Use your judgment.

Q: If you don’t have time to figure this out, isn’t rote rebalancing worth the risk to keep from being overly exposed to stocks before a bear market?

A: If you have a very long time horizon, you may be able to bear the extra risk by rote rebalancing. You will still have bigger drawdowns in the value of your retirement portfolio, but you don’t need the money in the short term and you can ride out the risk. My point is all investors need to understand that rote rebalancing is an active investment decision that increases risk.

Q: You’ve also done research on Bitcoin. The smart money is pretty sure it’s a worthless currency. What don’t people get?

A: Almost everything. For instance, part of the misunderstanding is the focus on the price of the Bitcoin. You see that it was at $1,000, then it’s down to $200. People say, “Well, the bubble has burst,” and stuff like that.

They are looking at just one aspect of Bitcoin. These critics don’t start by asking themselves, “What problem does Bitcoin solve?”

Q: What problem does it solve?

A: I am tired of constantly getting phone calls from my credit card companies, having to go online to fix the 20 things I’ve got auto-debits for, and dealing with charges that are not mine on my card. These are problems that many people encounter.

Q: Bitcoin is safer?

A: Bitcoin is much safer. When you go to buy something, the retailer actually is able to check a common ledger of all transactions to make sure you actually have the money to spend. The public ledger, which is almost impossible to hack, solves the problem of double spending—using the same Bitcoin to buy two things. Merchants, such as restaurants, which are paying 3% to the credit card companies, love this.

For me, though, I look at Bitcoin not just as a currency, but what it could do in the future in other applications. Think of the Bitcoin technology as a way to exchange and verify ownership. It’s like getting into your car with your smartphone. You present cryptographic proof of ownership. You’re the owner, and it’s verified through this common ledger. The car is able to identify that it is your car, and so the car starts. You’re done.

Now suppose you borrow money from the bank for the car and you’re three months behind in your payments. You present your key, the car doesn’t start. The bank has the key that starts the car. So this is a very cool idea, right?

Q: There’s still a problem with the roller-coaster ride in Bitcoin prices, right?

A: There is, and Bitcoin currently is not a reliable store of value because of it. But the price swings could be solved with more liquidity—more money in the market. The recently launched Bitcoin exchange, which is fully regulated, insured, and backed by the New York Stock Exchange, should help with this. Bitcoin price fluctuations are a factor of it being so young.

The best way to judge Bitcoin is not to look at the price progression, but to look at the vast amount of money that’s being invested by venture capitalists into Bitcoin-related companies. That’s what I look at.

MONEY Investing

5 Things No One Tells You About Owning Vacation Home Rentals

Beach homes
Rich Reid—Getty Images/National Geographic

Owning a vacation rental can be a good investment, but a lot can go wrong if you're not prepared. Here's what to know before you buy.

Owning a vacation home can be a great investment opportunity, but it is one that does have some risk associated with it. Before you ever purchase a vacation home, you should do your homework and plan accordingly. Here are 5 things that can go wrong when owning a vacation home.

1. Annual Returns Can Go Negative

Oftentimes vacation homeowners are faced with a negative annual return especially if they had a down year for bookings or if they had a major repair. Before you ever purchase a vacation home, you should look at all the monthly bills associated with the property and be comfortable enough with the total amount that you could pay on these bills even if the vacation home did not bring in any money.

Just in a few recent years, we have had a terrorist attack on American soil and the second worst financial disaster in the history of our country. These two events had a major impact on people traveling and the amount of disposable income they have to spend on vacations.

The second thing you must research before you buy a vacation home is to figure out the average nightly rate guests are willing to pay for a similar property and how many nights a year the property should be occupied. Once you have these two figures, you can easily find out how much income the property will bring in on an annual basis. When you compare the income to the monthly expenses, you should have a positive cash flow. If not, I would think twice about purchasing the property.

Related: 5 Expert Tips for Managing Your Own Vacation Home Rental

You can find most of the information you are looking for by asking your realtor, property managers who manage properties in the area, and by calling homeowners who list their properties on VRBO.com.

2. You May Not Be Able to Visit as Often as You’d Like

Life has a funny way of jumping in and keeping us from doing things we really want to do. I can’t count on my hand how many times homeowners have told me that before they purchased a property in Orlando, they visited 3 or 4 times a year. Then after they purchased their vacation home, they never seem to be able to break away and visit. You oftentimes find this as kids get older and get into sports or other activities that seem to eat up your weekends.

3. Repairs Can Come Up

You will need to put money back into your property every year to keep it up and maintained. The National Realtors Association estimates that you should budget for 1.5% of the cost of your home to be spent on repairs and general upkeep every year.

So if you purchase a $200,000 vacation home, you should budget to put $3,000 back into the property every year. Now, if you are renting your vacation home out to short term renters, you might need to budget a little more. Guests may not treat a vacation home as nicely as they would their own house.

4. HOA Dues Always Go Up

If you purchase a vacation home in a community that has an HOA, the dues will always go up. In all the years that I have been managing vacation homes, I have never seen an HOA reduce their monthly or quarterly dues.

Related: 8 Clever Ways to Save BIG on the Monthly Bills for Your Vacation Rental

5. Vacation Homes Do Not Always Increase in Value

Just as we talked about before, when we have a huge natural, manmade, or financial disaster, investors get scared and sell their investments. This is what happened in 2008 and 2009. Too many vacation homes flooded the market, and the price on the houses plummeted. Many people were not able to sell their vacation home for anywhere near the price that they purchased it, and this caused many houses to go into foreclosure and some houses to be sold as short sales. The longer you hold onto a vacation home, the better chance you have of making money on the property, but buying a vacation home is not a surefire money maker.

Owning a vacation home is a good investment if you do your homework and research. Many people rush to buy a vacation home for the simple pleasure of just saying they own one. Take your time; buying any good investment is a marathon, not a sprint. Don’t be afraid to walk away from the property if you are not totally comfortable.

This article originally appeared on BiggerPockets, the real estate investing social network. © 2015 BiggerPockets Inc.

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MONEY financial advice

The Investing Danger That Smart People Face

man sitting in front of a wall of certificates
C.J. Burton—Corbis

You may be brilliant and a giant in your profession, but that can get you into a lot of trouble.

While returning from a business flight last year, I experienced a queasy stomach sensation. Later than night I woke up with searing pain across my abdomen. At my internist the next morning, I asked, “Do I have food poisoning?”

“I would say something more serious,” the doctor replied. “We need to get you a CAT scan.”

Off to the imaging center. The radiologist came out: “You have appendicitis,” he said. “You cannot pass Go, you cannot collect $200. You have to go straight to the emergency room. Take this copy of your images.”

I checked in at the hospital and was triaged. I slumped in a corner, clearing my email and calling the office. Eventually a doctor came out and asked why I was there.

“I have appendicitis,” I replied.

“Really?” he said. “Did you self-diagnose on WebMD?”

“No,” I said. “I went to a radiologist. I have slides! Look at my slides.”

He did, and then he operated on me.

In recovery later that day, I realized my surgeon has the exact same problem I have: “Yeah, doc, I know you have a medical degree and 30 years of experience, but I’ve been reading WebMD and I think…”

Or in my case: “Yeah, Dave, I know you have an MBA and 30 years of investing experience, but I’ve been reading [pick one] Motley Fool/Zero Hedge/CNBC/TheStreet.com, and I think…”

What do I say when clients think they know more than I do?

At my firm, we work with executive families. Our clients are brilliant; many have advanced degrees from top universities. These clients have ascended to the pinnacles of their careers and are accustomed to being the smartest person in the room.

Trouble starts, though, when the clients confuse brilliance with experience. For the most part, the clients let us do our job, but every once in a while, we’ll get an order along the lines of:

  • “Buy Shake Shack in my account.”
  • “Put 50% of my assets in emerging markets.”
  • “Put 100% of my assets in cash! So-and-so says the sky is falling!”
  • “My 14-year-old has ideas for restructuring the portfolio.”

We could say, “That is a stupid idea. We are totally not going to do that.” But that approach leads to resentful clients who may take their resentment, and their account, to another adviser.

I prefer to use these requests as opportunities for education, laced with humor. Several clients asked us about the Shake Shack IPO in January. We showed them a simple metric: stock market capitalization divided by store count. We asked, “If Shake Shack is valued at $26 million per store and McDonald’s is valued at $2.6 million per store, do you think that the Shake Shack burger is ten times better than the McDonald’s burger?” That reality check then led us into a discussion of the risks and rewards of emerging growth stocks versus value stocks.

Clients have told me that picking stocks must be easy.

“Really?” I say. “Do you like to play poker?”

“Love playing poker,” comes the reply. “Every Saturday with my buddies.”

“Really? Do you ever go to Atlantic City and play with the pros?”

“Gosh, no! I’d get my eyeballs ripped out.”

“Really? You don’t have an edge in poker, but you think you do have an edge in stock picking, which is 10,000 times more complicated than poker? Really?”

I started investing at 17, so it’s not out of the question that a 14-year-old might have good ideas (though the same parents who think their child could manage their portfolio never allow that kid to drive their car). If a parent wants to involve a child, we’ll send that child several books on investing and instructions on how to “paper trade.” If the child is willing to paper trade for a year and show me the results, I’m willing to take his or her input. (That conversation hasn’t happened yet, but one day!)

Ultimately, there has to be a line we won’t cross. If a client starts sending daily orders, or even worse, jumping into his or her accounts and making trades without us, we have to fire the client. That is a no-win situation for us: Anything that goes well in the portfolio is because of the client’s brilliance, while anything that goes badly is our stupidity. We’ll set that client free to make room for clients who do respect our expertise.

———-

David Edwards is president of Heron Financial Group | Wealth Advisors, which works closely with individuals and families to provide investment management and financial planning services. Edwards is a graduate of Hamilton College and holds an MBA in General Management from Darden Graduate School of Business-University of Virginia.

MONEY stocks

Are International Stocks Still Worth the Risk?

As the Eurozone continues to face the Greek economic crisis and slow growth overall for the continent, many investors are wondering if buying international stocks is worth the risk.

TIME Careers & Workplace

10 Things to Consider Before Investing In a New Project Idea

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Getty Images

Following through on the wrong project ideas can be a big waste of resources

startupcollective

Question: What is one thing you ALWAYS do before green-lighting a new project or biz idea?

Test Assumptions

“There are lots of great ideas, but it’s easier to devise them than to execute them. So before you go off and try to execute new plans, it’s imperative you test some basic assumptions. If you already have customers, speak with them directly about the idea and take their feedback to heart. If you don’t, set up a landing page with an AdWords campaign to test response and prove the market exists.” — Adam Callinan, Beachwood Ventures

Ensure It Aligns With KPIs

“Before giving the go-ahead to a project or idea, it’s critical for me that the project aligns with our key performance indicators. If a project doesn’t drive to one of our key metrics, it’s likely not a worthwhile pursuit or use of resources. To have these kinds of checks and balances, it’s important to establish KPIs early on. Once in place, it’s a useful rubric to green-light ideas.” — Doreen Bloch, Poshly Inc.

Take a Step Back

“The worst thing you can do is pursue a new project or business because it sounds like an exciting opportunity. The problem is that pretty much every new idea seems like an exciting opportunity at first, but only the best of the best maintain that excitement weeks or months down the road. Set it aside and don’t think about it for a while. If you pick it back up and get just as excited, go for it.” — James Simpson, GoldFire Studios

Analyze the Pros and Cons

“I’m always thinking of new projects or business ideas to help grow our business, so I’ve developed a system to green-light them. First, I write them down and let them marinate for a few days. If the idea still seems legit, I’ll set up a call with my partner, discuss the plan/implementation in detail and write out a pros/cons list. We then analyze the data to make the final decision.” — Anthony Saladino, Kitchen Cabinet Kings

Run the Numbers

“Before moving forward with any new project, I want to make sure that it’s worth our time and the ROI is there. Numbers don’t lie. Financial projections are an essential tool for determining ROI and helping us make business decisions based on fact, not gut.” — David Ehrenberg, Early Growth Financial Services

Ask If It’s What People Want

“I see so many entrepreneurs, especially in the startup world, creating new businesses and products without even determining whether there’s a market for them or if people really want their product. Before green-lighting any new idea, I survey people, hold focus groups, run market tests through AdWords and even call people.” — Natalie MacNeil, She Takes on the World

Organize the Project First

“Before green-lighting a project, you should take the time to organize it. It is prudent to the success of the project or idea to know how long it will take, how it should be executed and who will be responsible before committing to a launch.” — Fabian Kaempfer, Chocomize

Define What Success Looks Like

“Without a clear definition of what success will look like for a given project, it’s impossible to tell whether it’s on track or even finished. By making a point of defining success before we even get started, we can decide how to measure a project and tell if it’s reaching the necessary goals.” — Thursday Bram, Hyper Modern Consulting

Run Some AdWords Tests

“Google AdWords is fantastic at validating market interest. I’ll run a few different ads over the course of a few days or a week to test how well they convert and at what rate. That tells me how crowded the space is and how strong the market interest is. Usually I don’t even create a landing page. Instead, I’ll send them to one of my other sites.” — Jared Brown, Hubstaff

Talk to Real-Life Customers

“Always test your ideas by talking to people in the real world before you invest tremendous amounts of time, energy and money. Don’t be afraid of anyone stealing your ideas. Get feedback in the wild. Even if it’s simply by sending an email to your customer list asking if it’s something they’d be interested in, that’s a start.” — Cody McKibben, Thrilling Heroics

The Young Entrepreneur Council (YEC) is an invite-only organization comprised of the world’s most promising young entrepreneurs. In partnership with Citi, YEC recently launched StartupCollective, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses.

This article was originally published on StartupCollective.

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