This blog is pretty young, and I'm not sure how many people read it, if at all. But even if there are no comments to this post, I won't be deterred :-)
Next week: Entitlement and why it will wreck havoc in your finances.
Friday, February 25, 2011
10. The tenth blog anniversary
I started this blog at 0, a few months ago. While I still have a lot of topics I plan to cover, I wanted to pause this week and ask you, my 6 readers: what topics would you like me to cover? What aspects, big or small, of investment you find interesting, or baffling, or just crazy? Use the comments below to voice your opinion, and thanks!
Friday, February 18, 2011
9. Book Review: Common Sense Investing (Bogle)
Common Sense Investing by John Bogle was my turning point. In a concise, clear, often funny and highly convincing manner, John Bogle rips apart the mutual funds and portfolio managers industries and shows the readers how we've all been systematically robbed, one percentage point at a time.
The premise of the book is pretty straight forward, almost mathematical. While reading it I took notes, amazed every time by how simple arithmetic makes it all crystal clear. I'll revisit many of these topics in forthcoming blogs.
Beating the market is a folly. Fund managers compete to beat the market. But on average they achieve market performance minus their commission. Is there any reason to assume that your account manager or the few mutual funds you chose are better, or knows more, than managers of Pension funds, professional investment houses, etc? Not really. So why should they make more than their peers?
Picking "winners" is a loser game. Not necessarily because markets are perfect, but because for every "winning move" there's a corresponding "losing move" - if you buy, someone else is selling. Do you think you're smarter than the average investor, including thousands of people who do it as a profession? Personally, I don't think I'm that smart.
Real growth vs. Speculation. Market returns are a combination of the economy performance (“real growth”) and investors confidence/speculation, as measured in average P/E. The former has had a steady annual growth of 8-9% in the last 90 years. The latter just adds noise, and cancels over the years. There's no way to measure it and project it, so just ignore it. P/E swings change wildly decade to decade. They reached an all-time peak of 32 in 1999, to drop back to 18 in 2007 (compared with 14 at 1920). The stock market is a giant distraction. It masks the steady growth of the US economy with speculations and mood swings.
Emotions and Expenses are your enemies. Discipline and following a plan will control the emotions. Avoiding commissions and fees will reduce your expenses to a minimum. Management fees of 1-3% are joined by sale charges (loads), commissions, redemption loads, exchange fees, bid-ask spreads, and of course taxes since the turn over of actively managed funds is high. The total cost of an active fund becomes 3-3.5% annually. Over the years, with compounding, this translates to a staggering loss of more than 50% of your money.
Index funds. Investing in index funds minimizes commissions and takes away the emotional problem of deciding when to buy or sell. You just buy a large index fund and forget about it, until you have money to buy some more. The S&P 500 is a great representative of the US economy, as it covers about 80% of it. Bogle recommends a broader fund, such as Dow Jones Wilshire Total Stock Market Index (formerly called Wilshire 5000) which is still 80% S&P 500. However, the two strongly correlate. From 1930 to 2007 they're produced identical returns. From 1920 to 2007 the difference is 0.1% annually. Over a short period one of them may produce better returns. The main advantage of the bigger fund is reduced volatility.
Passive vs. Active investments. Over the last 20 years, the S&P 500 beat 58% of the large-cap mutual funds. In fact, the situation is better since these comparison does not include funds that were so bad as to go out of business (“survivor-biased”). Passive investment through index funds that track the US market will therefore beat the majority of managed accounts and mutual funds.
Chasing past performers is a folly. Morningstar rating are largely based on performance from recent 3-5 years. People who follow this advice will buy funds that already have had their run. For example, the top 10 funds of the late 90s made 60-70% annually. Taking into account 2000-2002, they all dropped to the lowest 5% of all funds. Even worse – since investors tend to join these funds after they've “proved their success”, the dollar return of these funds is much worse than the fund return. For example, the #1 fund in this list made 13% in 1996-2002, but the average investor made -62% (i.e., this is the dollar weighted gain of the account). This is because the average investor joined the fund after it had its big run.
Reversal to the Mean. #1 fund of 1982-1992 was #100 the following year (a bit above average). #1 of 1995-2005 was #942 the following year (outpacing only a third of the other funds). This phenomenon (Reversion to the Mean) causes funds with good performance over a few years to decline afterwards and join the average lackluster performance.
Most mutual funds fail. About 2/3 of the funds created in 1970 didn't survive for 35 years. 99% of them had returns below or within 1% of the S&P 500.
Index funds win in "inefficient" markets too. S&P reports that the international index outpaced 80% of actively managed international equity funds. Similarly, the Emerging Markets Index outpaced 88% of emerging markets funds. People don't use Index funds since they want to feel they have control over their finances. With Index funds “ship and pray” method, one is encouraged to give up control and let the market forces do their work.
Endorsements. These recommendations are endorsed by 3 Nobel price laureates, investors such as Warren Buffet and mutual funds managers such as Charles Schwab. It's especially funny to read Schwab's comments: while he's selling bazzilions of expensive, exploitive mutual funds to his customers, he freely admits that he invests his own money in index funds. Go figure!
Highly recommended - have I said that already? Go get a copy now.
The premise of the book is pretty straight forward, almost mathematical. While reading it I took notes, amazed every time by how simple arithmetic makes it all crystal clear. I'll revisit many of these topics in forthcoming blogs.
Beating the market is a folly. Fund managers compete to beat the market. But on average they achieve market performance minus their commission. Is there any reason to assume that your account manager or the few mutual funds you chose are better, or knows more, than managers of Pension funds, professional investment houses, etc? Not really. So why should they make more than their peers?
Picking "winners" is a loser game. Not necessarily because markets are perfect, but because for every "winning move" there's a corresponding "losing move" - if you buy, someone else is selling. Do you think you're smarter than the average investor, including thousands of people who do it as a profession? Personally, I don't think I'm that smart.
Real growth vs. Speculation. Market returns are a combination of the economy performance (“real growth”) and investors confidence/speculation, as measured in average P/E. The former has had a steady annual growth of 8-9% in the last 90 years. The latter just adds noise, and cancels over the years. There's no way to measure it and project it, so just ignore it. P/E swings change wildly decade to decade. They reached an all-time peak of 32 in 1999, to drop back to 18 in 2007 (compared with 14 at 1920). The stock market is a giant distraction. It masks the steady growth of the US economy with speculations and mood swings.
Emotions and Expenses are your enemies. Discipline and following a plan will control the emotions. Avoiding commissions and fees will reduce your expenses to a minimum. Management fees of 1-3% are joined by sale charges (loads), commissions, redemption loads, exchange fees, bid-ask spreads, and of course taxes since the turn over of actively managed funds is high. The total cost of an active fund becomes 3-3.5% annually. Over the years, with compounding, this translates to a staggering loss of more than 50% of your money.
Index funds. Investing in index funds minimizes commissions and takes away the emotional problem of deciding when to buy or sell. You just buy a large index fund and forget about it, until you have money to buy some more. The S&P 500 is a great representative of the US economy, as it covers about 80% of it. Bogle recommends a broader fund, such as Dow Jones Wilshire Total Stock Market Index (formerly called Wilshire 5000) which is still 80% S&P 500. However, the two strongly correlate. From 1930 to 2007 they're produced identical returns. From 1920 to 2007 the difference is 0.1% annually. Over a short period one of them may produce better returns. The main advantage of the bigger fund is reduced volatility.
Passive vs. Active investments. Over the last 20 years, the S&P 500 beat 58% of the large-cap mutual funds. In fact, the situation is better since these comparison does not include funds that were so bad as to go out of business (“survivor-biased”). Passive investment through index funds that track the US market will therefore beat the majority of managed accounts and mutual funds.
Chasing past performers is a folly. Morningstar rating are largely based on performance from recent 3-5 years. People who follow this advice will buy funds that already have had their run. For example, the top 10 funds of the late 90s made 60-70% annually. Taking into account 2000-2002, they all dropped to the lowest 5% of all funds. Even worse – since investors tend to join these funds after they've “proved their success”, the dollar return of these funds is much worse than the fund return. For example, the #1 fund in this list made 13% in 1996-2002, but the average investor made -62% (i.e., this is the dollar weighted gain of the account). This is because the average investor joined the fund after it had its big run.
Reversal to the Mean. #1 fund of 1982-1992 was #100 the following year (a bit above average). #1 of 1995-2005 was #942 the following year (outpacing only a third of the other funds). This phenomenon (Reversion to the Mean) causes funds with good performance over a few years to decline afterwards and join the average lackluster performance.
Index funds win in "inefficient" markets too. S&P reports that the international index outpaced 80% of actively managed international equity funds. Similarly, the Emerging Markets Index outpaced 88% of emerging markets funds. People don't use Index funds since they want to feel they have control over their finances. With Index funds “ship and pray” method, one is encouraged to give up control and let the market forces do their work.
Endorsements. These recommendations are endorsed by 3 Nobel price laureates, investors such as Warren Buffet and mutual funds managers such as Charles Schwab. It's especially funny to read Schwab's comments: while he's selling bazzilions of expensive, exploitive mutual funds to his customers, he freely admits that he invests his own money in index funds. Go figure!
Highly recommended - have I said that already? Go get a copy now.
Friday, February 11, 2011
8. Math break: the impact of fees
How significant is an annual management fee of 1% or 2%? It looks minuscule compared with other rates we're dealing with when it comes to our finances: from sales tax (5%) to credit card interest (10-20%) to income tax (up to 36%).
We tip a waiter 15-20%. How bad can it be to give up a meager 1% or 2% to have a professional manage your finances? Don't they deserve this small token of appreciation?
Check this simple calculation. Assume you start with $10,000 that grow by 5% annually for 30 years. With no fees at all, you'll end up with $43,219. With 2.5% annual management fee you'll end up with $20,976, or less than half.
The assumptions leading to this surprising result are pretty mild: 5% annual return net of inflation, and a long investing horizon. True, an annual fee of 2.5% is pretty extreme, but even a 1% annual fee will reduce your savings by a quarter. And when index funds charge as low as 0.07% annual fee (check SCHB for instance, my choice for a broad-market US fund), there's no reason to give half your money to middlemen. Not even if they really, really need to upgrade their yacht.
Bogle points in his excellent book that mutual funds trail, on average, the S&P 500 by 2% annually, which happens to be their average management fee. In other words, the average mutual fund will give you long-term returns that are 43% below the index. Still want to invest in actively-managed accounts? No worries, I, and other passive investors will thank you.
Thursday, February 3, 2011
7. Why actively managed accounts are good for the economy
If you've followed my column, you should know by now that I'm a big fan of passive investment methods. The less you do, the better you'd be off.
Still, I'd like to recognize the benefit that my friends on the other side of the spectrum bring to the table. Yup - the day traders, the portfolio managers, all those poor sods who work hard to beat the average, or the investors who trust their money with them. I'm talking about people investing in your typical mutual fund, who scan Morning Star looking for 5-star funds; who read the balance sheets and quarterly results of S&P 500 companies; the people who believe they can beat the index, and are willing to lose a huge stake of their savings trying to be "above average". I'm talking about the fools who pay 2% and 3% and more in annual management fees; the day traders who pay hundreds of dollars a day in daily commissions to swap their assets with other day traders, enriching no-one but the banks and brokers.
All these people, through their sacrifice and futile quest, do bring an important benefit to the economy. To be more exact, they benefit me, and other passive investors.
You see, without all these pipe dreamers, there would be no efficient market. One of the premises of Index investing is that stocks are worth what they cost - there are no "winners" or "losers", since all the information available is already part of the stock price. But this is the case only because there are all these poor souls who spend days and nights buying and selling and making sure this is the case.
I wonder if a tipping point will arrive one day, when enough people invest passively to create inefficiencies in the market and real value for active trading. I think we're very far from this day. More-ever, we can rely on the enterprising, always optimistic, "I'm in control" spirit of the average highly-compensated executives and Wall Street sharks: there will always be people who think they're smarter than everyone else. Let's recognize these people for their sacrifice. Because it's their folly that makes passive investment work.
Keep on the good work, active investors! And thanks!
Still, I'd like to recognize the benefit that my friends on the other side of the spectrum bring to the table. Yup - the day traders, the portfolio managers, all those poor sods who work hard to beat the average, or the investors who trust their money with them. I'm talking about people investing in your typical mutual fund, who scan Morning Star looking for 5-star funds; who read the balance sheets and quarterly results of S&P 500 companies; the people who believe they can beat the index, and are willing to lose a huge stake of their savings trying to be "above average". I'm talking about the fools who pay 2% and 3% and more in annual management fees; the day traders who pay hundreds of dollars a day in daily commissions to swap their assets with other day traders, enriching no-one but the banks and brokers.
All these people, through their sacrifice and futile quest, do bring an important benefit to the economy. To be more exact, they benefit me, and other passive investors.
You see, without all these pipe dreamers, there would be no efficient market. One of the premises of Index investing is that stocks are worth what they cost - there are no "winners" or "losers", since all the information available is already part of the stock price. But this is the case only because there are all these poor souls who spend days and nights buying and selling and making sure this is the case.
I wonder if a tipping point will arrive one day, when enough people invest passively to create inefficiencies in the market and real value for active trading. I think we're very far from this day. More-ever, we can rely on the enterprising, always optimistic, "I'm in control" spirit of the average highly-compensated executives and Wall Street sharks: there will always be people who think they're smarter than everyone else. Let's recognize these people for their sacrifice. Because it's their folly that makes passive investment work.
Keep on the good work, active investors! And thanks!
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