Frequently Asked Questions
These FAQs are listed in order from what I think is easiest to most difficult.
Q1: My dad gave me a copy of your book last week. He knows I want to learn the basics of investing. (I have a decent-sized 401(k) and a small Roth IRA.) After taking a quick look at the book, it seems to be mostly numbers, and I’m not fond of numbers. What should I do?
A1: I suggest you just do the bare minimum due diligence: (i) Turn to p. 29 and see the gray-shaded numbers for the WSTL return and the S&P 500 return—14.16% vs. 11.22%, a very large WSTL advantage of 2.94% for 1970-2006, (ii) Read the two-sentence summary on p. 35 and (iii) Read the bullet points on the front cover. Now despite your number phobia, you know something about investing—perhaps enough to decide if you are going to be a WSTL investor. If so, all you need to do is watch when the WSTL changes color on the homepage of the website: from red to green [move money from a money market fund in your 401(k)/IRA into a low-cost S&P 500 index fund—see p. 51], from green to red (sell the S&P 500 index fund and put the proceeds into a money market fund for safety) and so on.
For readers who are willing to go beyond the bare minimum, here is some guidance. The book fits the 60:40 rule. You only need to read 60% of the book. The other 40% is for academics and market strategists who want to audit the WSTL model. They will find that the model is 100% legitimate.
Regarding the 60% of the book, it is much less number-filled than the other 40%. The Tutorial for The Wall Street Traffic Light (available at the About the Book button in the last two weeks of March 2010) recommends reading only eight chapters in the following sequence: Chapters 1-4, 11, 6, 7 and 5 (a total of 77 pages). Chapter 5 will refer you to Appendix A and Appendix B (a total of 7 pages). If you embark on this reading and study, let me know if the Tutorial helped you: harrisjohnk@hotmail.com.
Q2: When I hear stock market reports on the news, they always mention the Dow and sometimes the Nasdaq. The S&P 500 is rarely mentioned. Why is that? And why is the S&P 500 the only stock index used in your book?
A2: Excellent questions. The Dow Jones Industrial Average (the Dow) gets a lot of news coverage for three reasons: (1) It’s the oldest market index—its 103rd birthday was May 26, 2009, (2) It’s owned by Dow Jones & Company, the publisher of The Wall Street Journal and Barron’s and (3) It’s the largest number among the major indexes, which makes it seem more sensational. As a result, most people are more familiar with the Dow, even though it consists of only 30 stocks, representing about 27% of the total value of the U.S. stock market at the end of 2009. The Nasdaq is a good indicator of what’s going on with technology stocks and small stocks. This index represented about 25% of the total value of the U.S. stock market at the end of 2009.
In contrast, the S&P 500 is comprised of 500 (!) large-company stocks—all of the Dow 30 plus 470 others, including many Nasdaq stocks—and represented about 78% of the total value of the U.S. stock market at the end of 2009. The S&P 500 is a broadly diversified index that includes mostly multinational companies from all major sectors of the U.S. economy. The performance of the S&P 500 serves as a benchmark against which to measure the performance of mutual fund managers. Interestingly, the S&P 500 and the Dow generally, but not always, are highly correlated.
Q3: I see your website is free. For me, that brings to mind the old saying: “You get what you pay for.” What is your response?
A3: Great question! I want my research, which is available at the website, to be free because that approach is distinctly different from the high fees charged by much of the Wall Street community. “You get what you pay for” doesn’t apply to Google searches! The saying also doesn’t apply to actively-managed mutual funds. Over most 10-year periods, only a small percentage of those funds beat their benchmark indexes. In contrast to the WSTL’s low-cost (Fidelity’s and Vanguard’s S&P 500 index funds cost about 0.10% per year) and market-beating performance for 1935-2009, the performance of actively-managed mutual funds is dragged down by investment costs averaging one to two percentage points per year. Sure, some of those funds beat the market from time to time, but they don’t beat it for most 10-year periods.
Q4: The Wall Street Traffic Light focuses on using the WSTL strategy for tax-advantaged accounts [401(k)s, 403(b)s, 457s and IRAs]. Can the WSTL strategy be used for taxable accounts?
A4: The WSTL strategy can be used for taxable accounts to lower risk vs. buying-and-holding the S&P 500 but, because of the impact of short-term and long-term capital gains, the annual returns for those accounts would have been approximately the same as for buy-and-hold. Also, be aware that any attempt to apply tax rules, which have changed a lot over time, requires many assumptions.
Q5: Okay, I’ve read The Wall Street Traffic Light and have decided to use the WSTL strategy for a portion of my stock portfolio. Should I start now or wait until the next signal occurs?
A5: Start now. Just abide by the signal currently in force. For example, if the WSTL is green, go ahead and use the money you have earmarked for the WSTL to buy a Fidelity or Vanguard S&P 500 index fund (see p. 51). If the WSTL is red, put the earmarked money into a Fidelity or Vanguard money market fund.
Q6: I’m 35 years old. About 60% of my 401(k)/IRA portfolio is invested in U.S. stocks and another 20% is in foreign stocks. I’ve decided to use the WSTL. What portion of the 80% of my portfolio in stocks would you recommend I use the WSTL for?
A6: That’s strictly a personal decision that you (each WSTL investor) must make. For example, you could use half of the 80% for the WSTL. Then, 3-5 years after you begin using the WSTL, calculate which half of the 80% performed better. The result can guide what you decide to do for the next 3-5 years. Regardless of your decision, be aware that the returns from U.S. large-cap stocks, U.S. small-cap stocks and foreign stocks tend to be highly correlated over time.
Q7: How has the WSTL performed since your book was written?
A7: I wrote the final draft of the book in 2007 and published it in January 2008. The last year of data included in the book is 2006. For 2007-2009, the average annual return (the CAGR defined on p. 29) was 3.58% higher for the WSTL than for the buying-and-holding the S&P 500. For details, click on the Market Commentaries button, scroll down to Issue #1 for 2010 and find the 2000-2009 section. That 3.58% margin of victory for the WSTL is about ⅔ of a percentage point greater than the WSTL’s margin of victory for 1970-2006—the 2.94% on p. 29.
Q8: The WSTL has two colors, whereas a regular traffic light has three colors. Why doesn’t the WSTL have yellow?
A8: When a regular traffic light turns yellow, that signals caution: The light will turn red in a few seconds. The WSTL is not designed that way because, at any given time, the WSTL investor is either in a low-cost S&P 500 index fund or in a money market fund (or 3-month Treasury bills) for safety. While the WSTL’s green and red colors are the ultimate in simplicity, they are driven by various rules set forth in the book; for example, see the flowchart (p. 18) and Exhibit 6-2 (p. 48).
Q9: Is there an easy way to summarize the WSTL’s color patterns for the seven types of years listed on p. 14? Am I correct in saying that the WSTL is always green for the months of January and December, regardless of the type of year?
A9: The answer to both of your questions is yes. Here’s a road map for the seven types of years.
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Type of Year |
Year's Color Pattern |
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1A, 3A and Tier 2 |
Green throughout |
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1B and 3B |
Green, red, green |
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1C and 3C |
Green, red, green |
Note: Regardless the type of year, the WSTL is always green for January and
December.
Q10: Regarding Exhibit 7-1 (p. 57), does (can) a crisis event change the color of the WSTL?
A10: Although a crisis event could cause the WSTL to change color, that did not happen for any of the 17 events listed in Exhibit 7-1. WSTL investors don’t really need to concern themselves with the impact of crisis events on their 401(k)s and IRAs. Just check “In a Nutshell” on the homepage to see if a sell signal or a buy signal occurs. Keep in mind that, in any calendar year, there is never more than one trade out of and back into a low-cost S&P 500 index fund.
Q11: Is the WSTL just another forecasting model that has been derived by means of data mining?
A11: Data mining refers to making a detailed examination of historical data in an effort to find a relationship (a model) that beat the market during some past period. Those that disdain market timing sometimes quip, “If the data is tortured long enough, it will confess.” That is, a past market-beating model can be discovered. The hope of the data miner is that the model will continue to perform well in the “test period” and the “live test period.”
The WSTL model was developed by: (i) using two logical propositions and (ii) mining S&P 500 data—annual returns and daily closing prices—from the 1935-1969 period. The exact same model developed using 20/20 hindsight for 1935-1969 was applied to the 1970-2006 “test period.” And since my book was written, the exact same model was applied to the 2007-2009 “live test period.”
There are two logical propositions underlying the WSTL. First, over a period of years, the S&P 500’s annual returns revert to their long-term mean. Second, the S&P 500’s December low, which likely would be depressed to some extent by year-end tax selling, is a benchmark against which to measure investor psychology in the first part (or all) of the ensuing January-through-April period. This proposition gauges the S&P 500’s momentum. The references for the two propositions are pp. 4-6 and pp. 16-19.
Q12: In the week before the 2010 Super Bowl, my newspaper mentioned the Super Bowl Indicator (SBI). The article said the SBI has correctly predicted the stock market for 79% of the years since the Super Bowl started in 1967. In terms of performance, how does the SBI compare to the WSTL?
A12: I don’t know how the performance compares, but it doesn’t matter! That’s because the SBI and the WSTL are miles apart. The SBI says the stock market will rise for the coming year if the winning team was in the original NFL, and it will fall for the coming year if the winning team was in the original AFL. It is absolutely clear that the SBI’s track record is entirely due to luck (just like a run of good luck in Vegas). There is zero economic logic to support the SBI. But the SBI’s success rate makes for great press, especially for unsuspecting investors. On the other hand, there are logical propositions underlying the WSTL model, set forth in A11.
Q13: I can tell that the WSTL model has a very good, but not perfect, track record: There were two unprofitable trades during 1970-2009. Can you provide any stats on the notion of very good but not perfect?
A13: Your question is perceptive. Combining the test period (1970-2006) and the live-test period (2007-2009)—a total of 40 years, the answer is incredible:
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WSTL return > S&P 500 return |
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12 ÷ 40 = 30.0% |
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WSTL return = S&P 500 return |
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26 ÷ 40 = 65.0% |
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WSTL return < S&P 500 return by 0.45% to 5.08% |
1 ÷ 40 = 2.5% |
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WSTL return < S&P 500 return by 18.36% |
1 ÷ 40 = 2.5% |
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Is all of this WSTL history any guide for the future? In this case, history should be an excellent guide for the future, because it is not feasible that either of the propositions underlying the WSTL model (set forth in A11) will weaken.
Q14: I have a financial adviser, so is there any good reason I shouldn’t ignore the WSTL?
A14: Each investor must decide whether to ignore the WSTL or to embrace it. However, just because you have a financial adviser is not a good reason to ignore the WSTL. For example, if you decide to become a WSTL investor, you could easily manage the stock portion of your 401(K) and IRA portfolio yourself. That would save the fees you now pay your financial adviser for that service. Q&A15 considers your question from the opposite direction: If you become a WSTL investor, would you really need a financial adviser?
Q15: I’m impressed with what I’ve read about the WSTL. If I decide to become a WSTL investor, do I really need a financial adviser?
A15: Considering the broad range of services that financial advisers provide in today’s complex world, all investors need the help of one or more of them. Their services include:
Most of this list is self explanatory. But to answer your question, I will comment on the first three services.
● Regarding (1), to help prepare for or to reinforce a consultation with
a financial adviser, click on “About the Book,” then click on “To see
Supplementary Material,” and then click on “Setting Aside Money
for Investing.”
● Regarding (2), David Swensen, the long-time chief investment
officer of Yale University’s Endowment, made this very important
point in one of his books:
Asset allocation decisions play a central role in determining investor results.
A number of well-regarded studies of institutional portfolios conclude that
approximately 90% of the variability of returns [in any portfolio] stems from
asset allocation…
[Unconventional Success: A Fundamental Approach to Personal Investment
(Free Press, 2005), p. 12.]
Accordingly, smart investors pay close attention to determining
their asset allocation as they move through the seasons of life.
Without question, asset allocation has the starring role in the returns
generated by any portfolio. To help prepare for or to reinforce a
consultation with a financial adviser, click on “About the Book,”
then click on “To see Supplementary Material,” and then click on
“Fundamentals of Asset Allocation.”
● Regarding (3), WSTL investors use the sell signals and buy signals
to move out of and into a low-cost S&P 500 index fund with some
portion of their 401(k)s and IRAs. Since all stocks worldwide tend
to be highly correlated with the S&P 500 over time, my opinion is
that WSTL investors would not need the assistance of a
financial adviser to select stocks. Since many financial advisers charge an annual fee of approximately 1% of a portfolio’s market
value, implementing my opinion would result in an annual
savings of $10,000 for a $1 million 401(k)/IRA stock portfolio.
On the other hand, financial advisers can provide valuable
assistance to WSTL investors in selecting REITs, U.S.
and foreign bonds and cash equivalents.