24. Average is Good

Hard to be average, isn't it? When I used to date, the term "average" meant "below-average" (when it comes to character and personality) or "above-average" (when it comes to weight). It was never a good thing. Who wants to be average?

Yet, when it comes to investment philosophy, there are two important realization you should make:

1. Average is good enough.
2. Average is as good as you can have anyway.

The first insight comes from looking backward at the world economy and seeing the constant trend of growth, and how it's reflected in the stock market. Yes, there are setbacks: wars come and go, bubbles inflate and diminish as investors switch from irrational exuberance to gloom and doom every few years. At the same time, technology waves obliterate value and entire companies (Block Buster, Novell) while creating value in other areas (Netflix, Apple). But still, the overall picture is of growth - we make more, we produce more, we consume more, we create more, and our enterprises are worth more. This is why investing in the world economy has produced returns that are significantly above inflation for the last 100 years. If you ride this wave, you have excellent chances of achieving high returns. The numbers vary - some quote 8-10% average returns, or 5-6% net of inflation. These numbers assume very long term investing. Still, even people in their 40s and 50s should assume they can be invested for at least 30-40 years - there's no rule saying you need to convert everything you have to cash when you turn 65. Assuming a long investment horizon, you definitely want to ride this wave.

The second insight is that the market is so complex and so efficient that fighting it is futile. On average, all players in the market get, hmmm, average returns. This is the meaning of the term average, right? For every "winner" mutual fund (or a managed account professional), who beats the average, there must be a "loser", who gets below-average returns. You can't fight arithmetic. You can of course gamble - pick up a mutual fund at random, and you do have about 30% chance of beating the average (and 70% chance of ending up worse than the average). These are incredibly bad chances. Even casinos give you a 48% chance of beating them. The financial industry has gotten away with it for many years, but there's no way you should play their game.

There are many reasons for the below-average returns of mutual funds: excessive management fees, high turnover ratio, transaction costs and loads and tax inefficiency. We've covered all of that in previous blogs. But the main point is that the mutual funds and the account managers are fighting the windmills of the world economies and a market that is by and large efficient enough to force them into average returns.

By using a mutual fund or a portfolio manager you'll be signing up for diminished returns a priori, donating a fixed percentage of their account every year to the financial industry.

Bill Barker, writing for the Motley Fool, writes: "The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. For that reason, investors who are going to invest in mutual funds rather than in individual stocks should hold a very, very, very strong bias toward investing in index funds, which invest across the board in a stock market index." John Bogle in The little book of Common Sense Investing includes a graph of the number of mutual funds that have failed, on a year-by-year basis, to match the returns of the S&P 500. The results are staggering:

For once in my life, I feel that average is good.

23. Don't count on it!

An exclusive interview with John Bogle!

In Don’t Count on It, you discuss how we deceive ourselves, particularly with numbers. Can you describe what you consider to be the absolute worst illusion investors fall prey to?


The most damaging illusion for investors is their belief that they capture the stock market's return. For example, if the stock market provides an annual return of 7%, we know that the average investor's return will fall short of that by the amount of fees they pay. Those fees amount to about 2.5% annually for the typical investor, so their net return is down to 4.5%. Taxes might knock another 1% off of that, reducing the investor's annual return to 3.5% -- just half of the market's return. If you compound those figures over 50 years, $1 grows by $4.60 at 3.5%, and by $28.50 at 7%. In other words, the investor's cumulative return is less than 20% of the market's return. That's an enormous gap; one that can easily mean the difference between achieving one's long-term financial goals and falling well short of them.

If you could change just one thing about the practice of capitalism today, what would it be, and why is it the most important? 

The biggest problem with capitalism today is our tremendous focus on the short-term. Institutional investors--who own 70% of our corporations--are predominantly concerned with whether or not the quarterly earnings of the companies they own will meet the stock market's expectations. As a result, our corporate managers move heaven and earth to try to meet those targets, so as to keep their firm's stock price high and maximize their stock-based compensation. But building corporate value over the long-term is hard; there are no quick or easy shortcuts. And as the past decade has demonstrated, decisions made to boost earnings and stock prices in the short-term tend to end up destroying shareholder value over the long-term. The sooner we can realign our focus from the short-term to the long-term, the better for all concerned.


What do you think about ETFs? 

I like some; I am appalled by others. Specifically, I favor low cost ETFs that are focused on broadly diversified portfolios of stocks and bonds that investors can hold for a lifetime. These ETFs should provide investors with their fair share of whatever the returns our financial markets will provide. That's a winner's game.

On the other hand, I'm not happy with ETFs--the vast majority--that exist to enable investors to speculate, to play their hunches on which country or market sector will outperform or underperform over the short term. The turnover rates are enormous, holding periods are measured in mere days, and costs are far higher than those levied by broad market ETFs. That kind of speculation is a loser's game. So I believe that ETFs have the potential to play a significant role in the portfolios of long-term investors. Unfortunately, to this point their use seems to be dominated by those engaged in far more destructive investment approaches.

You talk about inspiring the next generation of leaders and your mentors in Don’t Count on It. What did your mentors have in common that you think is the most important trait in inspiring young people today? In other words, how can each of us be better mentors? 

I think at the most basic level, my mentors were good people; men of strong character who loved their work. They realized that the work they did made a difference in people's lives, and they did that work with a great deal of ability, pride, and professionalism. They woke up every day and tried their best to make the world a little bit better. That's what I took away from the relationships I had with my mentors, and the extent that I've been able to emulate them, I think, explains a great deal of what I've been able to accomplish in my own career.

My views on mentoring have a lot in common with the themes of Don't Count on It. That is, these relationships are largely built upon trust, and attempts to quantify them are doomed to failure. Mentoring, in my mind, is less about helping someone fill out a checklist of accomplishments, and much more about passing along the immeasurable qualities one needs to be successful in their field --character, professionalism, honesty, intellectual curiosity, even humor. If you possess sufficient amounts of those characteristics, you're likely to be successful in whatever field you work in.

To be completely honest, although the interview was probably exclusive, it was not done by your humble blogger. Still, this stuff was too good to ignore! 

22. ForEx and Magical Thinking

In my last visit to Israel I was asked for my opinion about a new, exciting, trendy way to make easy money. My friend N., a smart guy by any measure, recently went to a presentation about "ForEx", or foreign exchange trading. The idea is simple: currencies trade against each other all day long, and by identifying patterns that are "bullish" (the Sterling is rising!) or "bearish" (the Euro is falling!), you can buy low, sell high a few minutes later, and make tons of money. Better still, you don't even need to sit in front of the computer to do it: sophisticated software will identify these scenarios for you and issue buy and sell orders.

The presenter described how he'd been working for many years on developing 7 fail-proof strategies. He claimed that they have 90% success rate.  And of course, he'd be happy to share his success with all of us, out of the kindness of his heart. Charity has not passed from the earth!

Sounds too good to be true? Get Rich Quick schemes usually do, and this one is no exception.

Micro-trading has been around for a long while. Most day traders you'll see are broke, but ForEx day traders should be even worse off. The reason is that, while buying and selling stocks based on past performance is a folly, you at least own stocks -- which generally, over the long term, appreciate in value. You're just doing it in an especially counter-productive, expensive way. But currencies just trade among themselves, and the average yield on currencies is, by definition, 0%. 

When it comes to stock prices, academic research shows that past performance is no guarantee of future performance. Even worse, the past carries little to no information about the future, and whatever minimal gain you might extract from the analysis is lost when taking into account transaction fees. This is the random walk theory, made famous by Burton Malkiel in his groundbreaking book A Random Walk Down Wall Street. And no, the theory does not say that stock movements (or currency movements) are random - by all means they are based on the cumulative fears, hopes and of course information that traders have. The theory just states that they behave as if governed by random walk rules, in the sense that at any given moment, your current location (i.e., stock/currency price) is all the relevant information you can retrieve from the graph of the stock performance. IBM's stock price in the 70s is not relevant to whether it will go up or down tomorrow, or next month, or next year. IBM's stock price last week is as irrelevant. Add it all up, and you see that it's quite plausible that IBM's stock price in its entire history is not relevant to the prospects of the stock in future. 

But the human mind hates randomness. We try to find patterns in the world. When it comes to stars, it's called "astrology". When it comes to coffe, it's called Tasseography. And when it comes to stocks, it's called Technical Analysis.

The people who try to tell you otherwise use stock charts as crystal ball made of cups, deeps, heads and shoulder, fulcrums and other more exotic vocabulary of shapes. Based on these patterns, they predict where the stock is headed.

Of course, to be on the safe side, their predictions are always vague. Take for instance this guy (quoted from "A Random Walk Down Wall Street"):

The market’s rise after a period of reaccumulation is a bullish sign. Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the Dow, so it is clearly premature to say the next leg of the bull market is up. If, in the coming weeks, a test of the lows holds and the market breaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downtrend is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range.

Sounds familiar, right? Every time I read stock analysis it's a similar dribble. But if you read it again, this guy is basically saying that if the market does not go up or down, it's going to stay flat. Amazing. 

Or perhaps I don't give these people enough credit. As N. continued to tell me the story, we both realized that there is one safe way for making money with technical analysis and ForEx. And no, it's not actual trading. One of the questions you should always ask these geniuses is: if they're so sure of their analysis and their chances of success (90%, no less!), why are they wasting their time here, among mortals, instead of making millions and retiring to Ibiza? The answer is, of course, that the only way to make money out of this voodoo magic is to sell it. This particular course N. was offered was about $3,000. Multiply it by 10 fools a month and you'll get a nice income stream. Good luck!

21. What I learned in Paris

I've just returned from a 2 week vacation in Tel Aviv and Paris. It made me aware of one crucial aspect of retirement planning that I hadn't mentioned yet. First, some pictures:

The food in Paris was, as expected, superb. But what you can't see in these pictures are the price tags. Like tomatoes at the fancy food shop Hediard for 50 Euro per kg ($34 a pound). Of course, these are exquisite tomatoes, watered exclusively with the tears of virgin nuns from Mont St Michel (or so I imagine), and you can find cheaper ones if you go to the market. But sometimes you have no alternative. Consider for instance a common appliance like Kitchen Aid mixer:

589.50 Euro is equivalent to $884. Compare that with Amazon's price of about $200, and you can see that this is no coincidence - life in France is indeed much more expensive than life in the US.

Which brings me to today's point: your retirement planning is highly dependent on where you want to be when you retire. The cost of living in a big metropolis like New York or Boston is much higher than in smaller, rural areas. France and Europe are much more expensive than, say, Costa Rica. And if you don't mind third world countries, you can follow on my sister's steps and retire to Goa in India and live quite comfortably for $500 a month. 

Putting it another way, if your dollars don't allow you to retire where you are now, perhaps you should consider other alternatives? Just make sure you don't go shopping at Hediard! Especially if you're Israeli (their Hummus is 48 Euros per kg).