Discerning skill from luck: I hope you have some time on your hands

Statisticians (and college freshmen) use a "t" statistic to determine the "statistical significance" of an outcome.

The same statistic can be used to tell if an investment's track record is attributable to skill instead of merely luck.

After some algebra, the formula looks like this:

N = (t x sd/mean)^2

N = number of sample data points
t = t statistic; 2.0 is considered statistically significant
sd = standard deviation
mean = average of what you are measuring

Let's assume we have an investment that has generated an eye-popping 5% alpha (excess return) with a standard deviation of 20%
(the average standard deviation of the market from 1926 through 2008).

How long would the manager have to generate this type of track record to be reasonably sure that it was the product of skill and not luck?

N = (2 * 20/5)^2 = 64

64 years.

If the excess return is 4% (still unheard of), N increases to 100 years.
If the standard deviation is 30% (reasonable given the high returns), N increases to 144 years.

Hence the required regulatory disclosure included (usually in micro-print) in every brokerage statement:

"Past performance is no indication of future results."

Roth IRA conversion myth #2: "Tax is always paid at the margin"

Continuing the Roth IRA conversion theme (see previous post Roth IRA conversion myth #1), I'll elaborate on a very common misconception about taxes paid on IRA funds.

When you convert a traditional IRA to a Roth, you pay tax on the conversion at your marginal rate.  So a married taxpayer with taxable income of $100,000 would pay 25% on the conversion
(and if the conversion is large enough, some of it could be taxed at an even higher rate if the conversion pushes him into a higher bracket).

It's potentially a different story, however, if you don't convert.

Traditional IRA distributions may or may not be taxed at the margin.  In many cases, a taxpayer might pay significantly less than their marginal rate when they withdraw funds from their IRA.

Example:

Jim and Marge Gfarbnick’s sole source of income is their IRA withdrawal of $68,000 per year. If we ignore deductions and exemptions for the sake of simplicity, their marginal tax bracket is 25%. However, their actual tax liability is $9,375, or 13.8% (because of the progressive nature of the income tax system, some of the withdrawal is taxed at 0%, some at 10%, some at 15%, and only a small amount at 25%). In this case, they pay tax on their IRA withdrawals at a rate almost 50% below their marginal bracket.

Taking this example further, if they converted their IRA to a Roth just prior to retirement at their peak career earnings, then retired and began withdrawing funds from their Roth IRA to meet their expenses, it's likely they made a bad choice since their marginal rate probably dropped at retirement, not to mention their average rate (the rate at which they would pay tax on IRA withdrawals) was lower than both their pre-retirement and retirement marginal rates (and the timeframe was likely too short for the tax-free compounding of the Roth to offset the rate differential).

Takeaway:  your tax situation at conversion and withdrawal are an important driver in the conversion decision but the analysis goes way beyond just your marginal rates.

The cost of entitlement

The latest round of health care reform has produced a pair of bills which promise to not only fix the healthcare woes in this country, but to dramatically reduce the deficit at the same time
(the new plan could reduce the deficit by $138 billion over the first 10 years -- $20 billion more than the Senate bill, according to the CBO forecast).

Excuse me for being cynical, but I've heard this song and dance before:

"In 1967, the House Ways and Means Committee predicted that the new Medicare program, launched the previous year, would cost about $12 billion in 1990. Actual Medicare spending in 1990 was $110 billion—off by nearly a factor of 10."

So why were these cost estimates so far off?  The cost of entitlement.

The estimates failed to recognize or account for the behavioral change that occurs in people when they are promised a no-cost benefit.

"Roosevelt described Social Security as a modest offer to 'give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.'

Look what has happened since then. About 35 percent of Americans rely on Social Security for 90 percent or more of their retirement income. ... And Social Security is only one example. Over the years, the federal government has created a number of social insurance programs -- including the Medicare plans for doctors' visits and prescription drugs -- that provide significant taxpayer subsidies to even middle- and upper-income Americans.

We started these programs as a safety net for our hard-luck fellow citizens, and of course that safety net must remain strong. My point is that programs designed to help the needy should not become enshrined as benefits to which all are entitled. Too many of us who can afford to contribute more to our own well-being are jumping into the safety net instead. That approach is not affordable or sustainable. More important, it's not the American way."

--David Walker, Former GAO chief from his book, Comeback America.

The market bottom: one year later

Here we are, one year and 72% higher (S&P 500 with reinvested dividends) after the market bottom. Here are some choice bits of financial doom and gloom, all from within one week of March 9, 2009:

 

 

 

The above humdinger is courtesy of John Mauldin, a newsletter writer with
over 1 million subscribers.

 

 

"The man who thinks he knows something does not yet know as he ought to know."
-- 1 Corinthians 8:2
"Then the Lord said to me 'the prophets are prophesying lies in my name.  I have not sent them or appointed them or spoken to them.
They are prophesying to you false visions, divinations, idolatries and the delusions of their own minds.'"
-- Jeremiah 14:14

Related post:  Respect uncertainty

But what if something happens to you?

I occasionally get the question: "but what if something happens to you?"

Meaning, if I die or become incapacitated, where will my clients turn for help?

This question is often planted by brokers to imply that because they are employed by a big firm, their clients have a built-in succession plan (brokerage firms stand ready with a replacement, but a "court-appointed" broker typically isn't the type that is sought after).

So, here's the answer:  If I die or become incapacitated, you'll have to find a new financial planner.  Just like if your doctor dies, you'll have to find a new doctor.  Or, if your attorney dies, you'll have to find a new attorney.

A better question to ask yourself is:  "if my broker bails to another firm, do I want to be in the middle of a signing bonus quarrel while each party's attorneys squabble over who I belong to?"

If you are my client, you don't belong to me.  You've trusted me with the privilege of working hard on your behalf.  You are free to leave any time and I hope that the quality of my work acknowledges that I don't take you for granted.

Alas, if you must have a backup plan, here it is:

2009_12_16_robby_financhull_pl

"Now it is required that those who have been given a trust must prove faithful."
-- 1 Corinthians 4:2

For more on the "big v. solo" issue, read these related posts:
Small is the new big.  Solo is the new small and The power of one.

Investing lessons courtesy of the Austin marathon

The Austin Marathon makes a pretty bold claim on its website, one that ironically holds some valuable lessons for investors.

Here's the claim:

Deceptively Fast Course

 

The 2010 Austin Marathon is also a Boston Marathon qualifier and consistently produces one of the largest percentages of qualifiers, compared to other Texas Marathons. In fact, a comparison of finish times from the 2008-2009 Marathons of Texas season showed that for the average runner athletes in Austin ran more quickly across almost every age group. 


Marathoncomp

* The chart above was produced using official results from the indicated races from the 2008 - 2009 Marathons of Texas season. To compensate in differences in course closure times no runners finishing after 6 hours were factored into this chart.

Wow.  Those are some pretty impressive statistics.  If somebody is looking to run their first marathon, this would be a nice course to run it on.  And more experienced runners, those wanting to qualify for the Boston Marathon for example, would really like this course since the times are so much faster.

Or are they?

Lesson #1:  Consider the source

Always be skeptical of data interpretation that is produced by a party that has a vested interest in the outcome.

Lesson #2:  If it sounds too good to be true, it is

There's no logical reason why the Austin course should produce faster individual times than the Dallas course.  The Austin course has three times the vertical ascent and descent and neither is a point-to-point course so the net elevation gain/loss is close to zero on both.  

Lesson #3:  Don't confuse cause and effect

Their claim is that the course is significantly faster and they base this on data that shows that the average times across representative age groups are faster.  The data are true but the conclusion is not.

Lesson #4:  Data can say whatever someone wants them to say

If the course is significantly faster, then runners who finish both races should (at least on average) have faster times.  My cursory examination of the Male 30-34 and Female 35-39 age groups of runners who ran both the 2009 Austin marathon and the 2009 Dallas White Rock Marathon showed a significantly higher proportion of better individual times in the Dallas race, not the Austin race.

Lesson #5:  Logic and common sense are better than statistics

How about this for a better explanation.  The course isn't faster, the field (ie, the group of participating runners) is.  Austin has an extremely fit population while Dallas does not.  Dallas was ranked #14 (Houston was #6) in the 2009 Men's Fitness magazine "fattest cities in America."  Austin was ranked #17 on the same survey's "fittest cities in America."

If you ask a runner who regularly competes in both cities, they will tell you that relative to other runners, they are slower in Austin than they are in Dallas.

Fittestandfattestcities

Lesson #6:  Most of what you read is incorrect, misleading, or biased.  

"Always start your day with the truth (God's Word)... since you're likely to hear lies the rest of the day."
-- Steve Farrar